A Reddit user recently posed this question to her fellow community members:
Right now my fiancé and I have 2 student loans, 2 vehicle loans, small credit card debt, and a mortgage. We want to start the snowball debt payment method and want to apply a little more income to accelerate the process. My company contributes 10% to my 401k regardless of what I contribute. Is it wise to take the 5% I would normally contribute and apply it to our debt payoff?
401(k) plans vary in quality, as do the policies of the companies that offer these plans to their employees. The fact that this employer contributes 10% of an employee’s salary to the 401(k) plan automatically is amazing, but rare. In another thread on Reddit, the same user recently mentioned she is 26 years old, earning $58,000 a year. The $5,800 she automatically receives in her 401(k) is a benefit that could make any saver jealous.
Through the recession, many employers stopped contributing to their employees’ 401(k) plans, and most employers’ contributions are activated in a way that matches some level of the employee’s own contributions. That is, if the employee chooses to receive all of their income in their paycheck rather than contributing to the 401(k), the employer contributes nothing. Some companies that eliminated their matching contributions are starting to bring them back, but often at a reduced level.
It’s hard for financial planners to provide accurate advice when their audience covers a wide variety of situations, but the general opinion seems to be that 401(k) plans are good as long as there is an employer contribution included. Take this away, and you generally have a high-cost investment vehicle that only allows certain investment choices, like expensive, actively-managed mutual funds or annuities. The tax-advantaged nature of 401(k) accounts can be positive, too, but someone early in their career might be better off paying tax now, while their income is relatively low and while income tax rates are historically low.
Economists tend to think that income tax rates can’t stay this low for long, so the known amount of tax you’d pay now will likely be less than the unknown amount of tax you’d pay when you retire. Future tax estimations are at best guesses. Economic life forty years from now could present situations barely imagined today.
Consider it takes no effort on this Reddit user’s part to receive the full benefit of the employer’s contribution to the 401(k), I suggest not investing in the 401(k) until all other investing and debt payoff options have been exhausted. That includes starting a Roth IRA, building an emergency fund, and paying off debt. The priorities of each change depending on how much you have available. 5 percent of $58,000 is $2,900, or about $240 a month.
Assuming this Reddit user is already paying off debt, I would just split this amount in three. Add $80 a month to debt payoff, $80 a month to establishing the root of an emergency fund, and $80 a month to a Roth IRA. From there, shift priorities in favor of debt payoff if any of the interest rates on the debt is higher than 4 percent or so: perhaps choose $120 towards debt, $60 towards savings, and $60 towards the Roth IRA. The user should also shift priorities in favor of the emergency fund if she believes her income stream — the job — is even a little at risk and if there isn’t any other savings to help pay for expenses if income disappears.
When it comes to paying off debt, I suggest the Debt Avalanche rather than the Debt Snowball, but unless there is a large amount of debt or the interest rates vary wildly, there isn’t that much of a difference between the two methods. With the Debt Avalanche, at least you have the satisfaction of knowing you aren’t spending one cent more to pay off debt than you need to.
She has flexibility with that 5 percent of her salary because her amazingly generous employer contributes to her 401(k) regardless of whether she contributes herself. That’s a rare situation, and I suggest taking advantage of it completely. The employer’s contribution is the best feature of any 401(k) plan, and there is a more difficult question for those employees who do not have this benefit in any form: whether to contribute to the 401(k) at all.
I am not a financial adviser or planner. These opinions are based on my own observations. If you are concerned about your financial situation or have questions about choices that affect your finances, you should seek help from a professional.
Published or updated June 19, 2012.