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Between a Rock and a Hard Debt

This article was written by in Investing. 38 comments.


Well, I didn’t want to have to make this decision, and I know that all of you smart people will think I’m making a mistake, but I’ve decided for the time being to stop making pre-tax investments into the 401(k)-like thing that my company operates.

Over the last year I’ve directed $1,879.18 out of my paycheck into that IRA, and as of yesterday the account was worth $2,181.61, which is an increase of $302.43. That’s an overall return of just over 16%, which is well outperforming the Dow Jones and the S&P 500.

Unfortunately, I’ve still got this credit card debt hovering between $5,000 and $6,000, and the finance charges are easily outstripping any benefit from investing in the IRA. I feel like I’ve made a terrible mistake by taking the advice of the CPA I consulted, and that I could be feeling a lot better about my future right now had I not started investing.

This decision was made easier for me when I remembered that the main benefit of contributing to the IRA was that my employer was also contributing free money in my name, and that they stopped last year around the same time all of our salaries got a 10% reduction. What’s more, this particular investment comes with a front-loaded 5.75% transaction fee. When my employer was contributing, this fee was annoying but not enough of a deterrent. Now, if I felt like I should be contributing any pre-tax money, I could find a better option just about anywhere that didn’t charge me that much.

So, I’ve stopped. And now I can pay off my credit card at a rate of $1,000 per pay period instead of $900. Of course, I’m still using this card for daily purchases, so it won’t be paid off in three months, but I have managed to start making lunch instead of buying it every day. If it weren’t for the ever-present vet appointments, car maintenance ($518 for new tires), out-of-the-blue-surprise dermatologist bills ($178 for stuff I thought was already paid for a year ago, because we have the best health insurance in the world), and of course the dentist (nearly $800 so far), I’m sure that debt would seem a lot more manageable.

I’ll probably have to stop making dentist appointments, too.

Published or updated January 18, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Smithee formerly lived primarily on credit cards and the good will of his friends. He is a newbie to personal finance but quickly learning from his past mistakes. You can follow him on Twitter, where his user name is @SmitheeConsumer. View all articles by .

{ 18 comments… read them below or add one }

avatar savvy

Do you have an emergency fund in place? If not, that should be your first priority. Then unexpected expenses (like the old medical bill) won’t have to go on the credit card. I’d also suggest NOT using the credit card for daily expenses. Use cash/debit only for that and the whole $1000/mo will go to debt repayment.

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avatar Randy

Why are you using the card for daily purchases? You’ll pay interest on those too. You could get another card for daily purchases and pay it off each month with no interest. They pay as much as you can on the one with a balance.

Don’t you love how everyone has a better idea?

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avatar Jackie

I wouldn’t contribute to a 401k with a fee like that either if I had other options, and I don’t think that putting a moratorium on contributing to retirement for 6 months or so is the end of the world, but…

I don’t think the extra $100 per month is really the issue. If you really want to get out of debt, you have to stop borrowing money period. Change your mindset.

We all have expenses like vet bills and car repairs (although I would argue that those are NOT unexpected expenses at all — if you have a pet, they will need to visit the vet, and if you have a car, it will need work.)

Changing your mindset means that when you are presented with a bill you hadn’t prepared to pay, you will reach for extra work instead of for your your credit card. Or you’ll ask if there is any way to reduce the bill. Or you’ll sell some stuff. Or you’ll use your emergency fund. You’ll do anything other than borrow.

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avatar JT

Hey Smithee!

The smart people would have told you to stop contributing last year when you lost your match; especially if you’ve already got sizable credit card debt. The minute I lost my employer match I stopped all of my contributions. If you don’t get a match then the order of operations should be to max out your Roth first then move to a 401k.

To be honest, 401k’s are the scam of the century. You have no options, or at most a very few, and you can’t do anything about it. The only good thing is the match. The pretax thing is okay, but it’s just going to come back to bite you 40 years from now. I’d much rather pay my taxes up front considering we have no clue what tax rates will look like decades from now; I’d argue they’re going to be much higher, if anything.

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avatar Holly

I, too, am feeling let down by my husband’s 457(b) plan with all of the fees and administrative charges. Even our little Roth IRA is still worth $1000 less than what we have contributed….it has high fees as well. I may be doing the same thing and cutting or eliminating contributions. I have dental bills as well….two kids w/braces…$7500 so far, OUCH!!!!

We have the numerous vet bills as well. I feel your pain. Thanks for sharing.

Needless to say, we still tell my oldest to become a dentist! LOL

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avatar Revanche

I understand the big things coming out of the blue, but as previously mentioned, why are you using the card with a balance on it for daily purchases? I presume that every new purchase using that card is charged interest because you’re carrying a balance, there has to be an alternative to using the same card for debt and purchases. I know it seems like it’s the big stuff draining your ability to pay off the card but it’s also the small stuff. Both sets of plugs need to be in place.

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avatar Jim

Now that you lost the match, I think its a good idea to stop putting money into that fund. Especialy since they have a 5% sales load.

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avatar Evan

One of the benefits of the 401(k) is the loan option. I have NO idea about your balance, but you may be able to consolidate your CC loans into a lower interest one from your 401(k)? Then pay it back quicker.

This still doesn’t solve the problems highlighted by the previous 5 or 6 commenters concerning your addiction to credit.

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avatar Dan

1. I’m slightly confused because smithee is referring to a “401k-like thing” and an “IRA” interchangeably. Does her employer operate a 401k or an IRA for her?

2. What everybody else said, ESPECIALLY about using the card you’re carrying a balance on to pay daily expenses.

3. JT, assuming smithee has the ability to invest in a traditional IRA and receive the tax deduction for it, I’m no longer convinced that investing in a Roth is the unquestionably smart thing to do. Yes, there is a lot of uncertainty with what the tax structures are going to look like 20, 30, or 40 years from now. And, if taxes are going to be hiked significantly, I don’t think Roths will be safe from them — there’s absolutely nothing prohibiting congress from enacting a law that would pass a levy on the Roth.

So… assuming the brackets have some resemblance to what we have now, consider this: We make our Roth contributions at our marginal tax rate, but we won’t pay our marginal tax rate on our 401k/IRA withdrawals. Assuming one fully retires (which is why we have this stuff in the first place) one must remember that in today’s dollars, for those married filing jointly, the first $18,700 we withdraw incurs no tax liability! (That’s the standard deduction for MFJ, and two exemptions.) Today, the 10% bracket tops out $16,700 and the 15% bracket tops out at $67,900. For the sake of discussion, assume most MFJ’s are comfortably in the 15% bracket. That means any Roth contributions are being taxed at the 15% rate. If a couple were living off of IRA/401k withdrawals alone, they would incur no tax liability for the first $18,700 in income/withdrawals. On an income of $35,400, they’d pay a 10% tax on only $16,700 (or a total of $1,670) This would “feel” like a net tax of 4.7%!

Keeping in mind that tax brackets, deductions, and exemptions are indexed for inflation, some reasonable calculations for my own personal situation suggest that I might have a required minimum distribution of $133,000 in the year in which I am forced to make my first RMD. I estimate a tax bill of $9,700 on that income, or 7.3%.

Even if taxes are hiked a few percentage points over the years, I’m far from convinced that Roth contributions are an unquestionable must over anything else. If taxes do go up, they likely won’t increase drastically overnight — that means your future contributions are going to be taxed at a higher rate, too. So even if the tax rates doubled and the brackets stayed the same, I’d still pay an effective 14.6% on my 401k withdrawals, while you could be paying 30% on your contributions! (It’s interesting to note that even if the tax rates doubled by the time I withdrew, my net effective tax is still less than what I would have paid TODAY on my Roth contributions.)

I realize that I make a lot of assumptions in my scenario, but those have more to do with tax brackets, standard deductions, and exemption amounts. For me, (and for most of the middle class) too many things have to change before a 401k/IRA becomes the wrong choice. And that’s not a bet I’m willing to take.

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avatar Holly

Dan – Thanks for questioning the pro-Roth mindset; I could never understand why everyone says to invest in a Roth if you expect you will be in a higher tax bracket upon retiring. I thought, “Wow! We would have to be VERY serious investors to fall into a bracket that’s higher or as high as the one we are in today.”

But then these pro-Roth people are also those who argue that the Feds will impose higher taxes on us down the road. But, as has been stated, they should also realize that there is always the question of whether our (expensive) Roth distributions will remain untaxed in the future.

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avatar Dan

Holly, thanks. A diligent investor can easily fall into a bracket that’s as high as he is in today. In today’s dollars, the 15% bracket starts at $16,700, which after deductions and exemptions for the MFJ is $35,400 in taxable income. That’s the required minimum distribution for someone with $1 million in their 401k/IRA right now — which would be the equivalent of someone saving $300/mo for the last 40 years and getting an 8% return on their investment. To put that in “our” dollars, that $1 million today would be worth $2.8 million or so in 2050 dollars. At an 8% annual return, that would require investing $840/mo. That does sound like a lot in today’s dollars (and it is) but my calculations assume level payments. (And assuming one gets a 50% match from his employer, he’d only need to invest $560 out of his own money — pretax — so his net contribution excluding state taxes is more like $476.)

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avatar Eric

Yeah Smithee…you need to get on that debt. You’ve been titter and tottering around it for awhile now. Just knock it out as quick as you can and stop any superfluous spending. As for the 401K, always contribute up to the match. Since it’s been stopped though, you’re right in pausing the contribution for now.

But remember to change your investment. Who the hell pays a 5.75% front loaded fee? If all of the funds are like that, two words: ROTH IRA. Get on it! Good luck!

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avatar Eric

(subscribing)

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avatar David C

I agree with the move to stop retirement contributions, but I hope you were joking about the dentist visits. Your mouth’s health is a good lead indicator for your overall health, and it would be better to pay now than let your health slide and pay later.

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avatar JasonK

I’ve done you one better Smithee. I Cashed out half of my 401k…took the massive tax hit and paid off all of my credit card debt which was substantial. The other half was rolled into a Roth. I’ve read all of the stories of how you’re not supposed to do that but carrying that debt around and feeling like I was making no progress getting rid of it was too much to bear. I’m young enough that I’m not worried too much about it. The new job I just took has a good 401k plan where they actually do a match unlike my last several jobs ;) I’m sure someone will comment how awful what I just did was but too bad. It was my money and my piece of mind. I’m not planning on going into debt again (I wasn’t using any of the cards at all for years….just paying them down). I know have hundreds of dollars a month I can use to get my emergency fund back into order.

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avatar Holly

Thanks for the breakkdown, Dan –

Currently, we are counting on my husband’s pension (he is a police officer), and possibly a second pension if he goes into a second career thru early retirement as he is planning, to be the main amount we retire on. Very doubtful we will have any where near 1 million invested with an 8% return (we had only just started seriously investing in his 457(b) 5 years ago. I am 40 y/o…we have lost about 25% so far). We also plan to downsize to a much smaller house once our youngest leaves the nest (10 years time).

We have been investing in a Roth consistently since 1997, and its present market value is also below our contrubution amount.

We are in deep $*** if he somehow loses his pension benefit. We will not get a SS benefit.

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avatar Brian

I would stop contributing to it also, if I didn’t get the match. Thankfully, my company is still matching, but if they stop, I stop, and I start migrating that money to a Roth IRA. I think you’re making a good choice!

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avatar Britt

Excellent decision. You won’t regret it. Pay off the high interest credit card debt first. Since your company stopped the match, it doesn’t make any sense to do otherwise. And the odds of getting another 16% annual return on the stock market investments in the coming year are very low. So it’s a good time to stop those contributions. After you pay off the debt, go back to your regular investing. But you can definitely find a low-cost online discount broker for an IRA or Roth IRA who will not charge front-load fees, annual fees, or anything but low one-time charges for buy and sell orders.

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