Question for Readers: Get Rid of Debt Before Investing for Retirement?
Joe sent me a question about priorities. He feels his chosen career path is not one destined for the big bucks, but in pursuit of said career, he has racked up some debt. Fair enough, that’s a common situation. He also has some decent retirement investing options laid out in front of him by his employer.
The perennial question is whether it is worthwhile to wait before taking advantage of his employer’s matching retirement contributions in order to to use what cash he has available to pay off debt.
His full email and my response follow. Please feel free to add in your opinion in the comments. I am not a financial advisor and I know I have readers who have experienced all kinds of situations and have infinite wisdom as a collective.
I am 30 years old, and will be getting my BA in urban planning next Spring 2008. I have already incurred roughly $12,000 in subsidized student loan debt. I plan on going to grad school in international development, so I’m not “banking” on a super lucrative career (but who knows?). Anyways, aside from my student loan debt that I have and will continue to pile on, I have roughly $6,000 in car financing debt left. I currently have about 5 credit cards with small limits on each one totaling about $5,000 in debt, but a few of them have really high rates (one has 28% – yes I know I have to get rid of that puppy!).
Now, I work at a university where they allow me to contribute 5% to a Vanguard retirement account and they match 10% into my account. I signed up for it, but now I am thinking that was a mistake. Should I not get rid of the debt before I invest in retirement? Money is pretty tight for me since I am still a student so even if they take about $120 a month from my paycheck, that is still a relatively big chunk for me. Also, if I will not be going to grad school at where I am currently employed, or if I don’t have a career here (I don’t think I will), then wouldn’t it be wiser for me to opt out of the Vanguard retirement account since I would only put money into it for about a year and then close it out? Wouldn’t it be better if I just put the money towards eradicating debt?
Lastly, I have something called a CAP account where I earn between 7-8% interest which was left over from my last employer. I cannot put any money into that account and it has not made a lot of money over the years so I am thinking about cashing it out and using the funds (even if I lose 20% to the government) towards paying off debt. Also, I have another dormant retirement account with TIAA CREF worth about $1,100 so I am thinking of cashing that out to pay off debt too.
Do you think I am thinking wisely here or would you recommend a different course of action? Any feedback would be very appreciated.
Joe: If you can make your minimum debt obligations while investing as much in your retirement fund to take advantage of the full employer match, that is the best option. Every paycheck that goes by in which you are not fully taking advantage of your employer’s free money, is money you will never see down the road.
That being said, 28% is a horrible interest rate. You must get rid of this debt as soon as possible… but I would not take a $220 penalty on your previous employer’s retirement plan at TIAA-Cref to do it. There will always be time to pay off debt. The sooner you invest for retirement, the longer your money has to accumulate. Compound interest, as Albert Einstein supposedly said, is the greatest mathematical discovery of all time.
Now, when it comes to debt, there are strong opinions that say that it is best to eradicate this liability above all else. This is primarily an emotional argument, not mathematical. It’s up to the individual first to determine what is mathematically the best option — what will put the most money in your pocket down the road — and then factor in emotional considerations, which differ from one individual to another.
Now it’s time for Consumerism Commentary readers to chime in.
Article comments
When I left my former company, I had 30K in my 401K (Vanguard). I left the money in there for 5 years untouched without contributing anymore and in 5 years it doubled. You don’t need to cash it out or roll it over once you stop working for them if the balance is high enough, they should let you leave it there. Comments previously posted about lowering your taxable income is a major plus (less taxes you pay), the free money from the company, and the time your are giving yourself for compounding would be foolish to pass up. I would consolidate the 2 smaller retirement accounts with the Vanguard instead of paying off debt with it. They tax you and they have early penalty fees etc. for cashing out retirement accounts.
It may feel overwhelming to be in debt but I’ve learned to deal with it. It’s worst when you are younger, still in school, and maybe just starting a family. It’s probably worst if you live in California like me. he he. I agree that this is also an emotional decision. But think about how you would feel later on in life when you passed up saving for your retirement earlier and the amount money you could have accumulated.
I would tackle the highest interest rates for the credit card or as suggested by others above transfer it to 0% interest. The amount of debt you have is not very high in my opinion. I know people who come out of school with much more student loan debt than 12K (try 60K). Everyone has car loans. 5K in credit card debt is also not very significant in my opinion as long as you have a plan in paying that off.
Dear flexo:
Take it from someone who been there…you’ll be glad you took the matching funds and put it into that Vanguard retirement fund!
I had the same deal-5% and 10% matching-30 years ago. I left the university after only paying in a few thousand and didn’t pay in anything more. 30 years go by, and I have some retirement money! Lots more than I could ever save up now.
You don’t know it yet, but it’s going to be way harder to save up that retirement money later.
So, keep going on the current matching funds and don’t touch the other retirement funds, either, unless it is to roll them over into another IRA and leave them alone to grow. Just pay off your other debt as quickly as you can from what you are bringing home. If the 28% hurts (and it should), refinance to a better rate.
Joe,
I think Brian hit it on the head. The company match is too good to pass up. Even if it for only one year, that is still a lot of free money.
There is also a good possibility you can work with your credit card companies to lower your interest rates, or you might even be able to get a balance transfer on a new credit card with a low or even 0% interest rate. This would be a great way to save a lot of money, as long as you can commit to not adding new debt.
Flexo, this is a great reader question and I agree with your response. I would take full advantage of an employer´s match. That said, so often we see these decisions as mutually exclusive–either pay off the debt or invest for retirement. If debt makes you uncomfortable, why not do both. Pay a little extra on the debt and begin investing for retirement, even if you can´t take full advantage of the company match. If I had waited to begin investing until I could afford it, I never would have invested.
Joe,
If I understand the situation correctly, the best financial thing to do would be to take the company match and find a new home for the debt on the high interest credit card. Try calling the companies you have cards with and asking them to give you a low interest rate for a balance transfer. Be sure to pay attention to the “catches” like a high interest rate after the promotional period, high transfer fee, etc.
As some have mentioned, though, the financial answer may not help you sleep better at night. If you are really worried about your credit card debt, perhaps you can split your money between the retirement account and your credit cards. This way you sleep better and can still provide for your retirement.
Joe,
What will make you sleep better at night? For me, being debt free will, which is why I set aside my 401k for 12 months (in month 3 now) to pay off all of my debt (except my house). Am I missing out on my employer match? You bet. But I sleep better at night. And one year of not saving for retirement will not make or break you down the road. Sure, you will miss out on some money from the match and interest, but how much is your peace of mind worth?
I say do not contribute and pay off the debt. But make sure you condition yourself to not get back into debt. Once you are out of debt, save an emergency fund, then save fore retirement.
jsut my two cents.
ntguru
Yes I am positive that they match 10% of my contribution. If I do not put in anything, they put in 5%, if I put in 1% they put in 6% etc etc.
But yes I get your point, it is free money.
Joe, are you 100% sure they are technically matching your contribution? Many .edu’s contibute 10% of your salary regardless of your contribution.
Assuming that is not the case, and assuming there is no vesting schedule, everyone is right…It’s basically free money. It doesn’t matter if you’re planning to leave in a couple months or retire there.
Slight mistake on last post, it’s $100 if that is the 5% of your monthly income, it is not a program that lets you put more than that 5%. And yes I get vested right away.
Flexo and everyone else, thanks very much for your feedback on my problem. It is all very useful information, however the question remains whether it is worth it to invest in the retirement plan if I am not sure I will be attending grad school at the university I currently work at? Yes, they match 2:1, so e.g. if I put $100 monthly then they put $200, but let’s say I go to another school out of town, then is it really worth it? Instead of putting the $100 into retirement wouldn’t it be smarter to pay $100 monthly towards getting rid of the credit car debt? This is what I am unclear about. I get the gist of what you guys are saying but the issue is, if I only have about a year left of employment here then I am trying to figure out the best course.
Thanks so much for your opinions once again!
Joe
I would make minimum payments on everything and put extra funds towards paying off the CC debt 1st. Then I would contribute the minimum to get all the matching funds. Then I go after the SL debt until its gone with what’s left. Then you have no debt and you can save what you used to have in payments and don’t have the burden of debt.
You can’t go wrong with that.
Flexo nailed it when he said this is primarily an emotional (not financial) decision. The correct answer is: do whichever you think is best. If you prefer to be debt-free, pay down the cards and student loans. If you are cool with debt, invest.
Some people will point to the financially correct answer and say that’s all there is. I argue that there is true value in things like the peace of mind that comes with being debt-free. It’s intangible, yes, but valuable nonetheless.
Our student asked: “wouldn’t it be wiser for me to opt out of the Vanguard retirement account since I would only put money into it for about a year and then close it out?”
No, DON’T close it out. That’s a mistake many people make when leaving a job. Not only do they lose out on future tax-deferred growth, they get hit with a 10% penalty.
If the fund custodian won’t allow you the leave your funds there, or maybe even if they will, roll the funds over to another custodian. Which might be a rollover count with … Vanguard.
Another thing to look at is the vesting rules for the plan. Are you vested in the match right away? Or do you have to work there for awhile before you are. Get a copy of the Summary Plan Description and read it.
I’m a strong advocate of paying down debt while also investing. Of course this depends a lot on the situation.
As people have already mentioned, if there is an employer match involved, you must take advantage of it even if you are carrying debt. But also, if there is no match involved and you are struggling to make more than the minimum payment on debt that has a high interest rate it makes sense to knock that out first.
But when you’re talking primarily student loan debt, a company match and the power of compounding by saving even a little bit at such a young age makes it a clear case for investing while still working to pay down the debt at the same time.
Definitely max out the company match. The only reason you wouldn’t is if your company has a vesting policy for the money they match. My company has a vesting schedule that says that if I leave before I’ve been with the company for four years, I get small percentage of their matched portion. So if they have this vesting policy and you’re going to leave in a year, it’s probably not worth it.
Also, transfer your high interest rate credit cards to lower ones. There are lots of 0% interest on balance transfers out there. You might even be able to find a debt consolidation loan to help.
I am with Jonathan on this one. If your employer is matching, you should take it. Remember, anything they take out before taxes saves you roughly 25% (if you are in the 25% tax bracket.) I wouldn’t cash out the $1100 either. It may seem like no big deal now, but again the power of compound interest.
If my own situation helps any, I’ve got about 20K in credit card debt I’m working to pay off while still contributing 10% to my 401K plan. The credit card debt is all at 4% or less, but by saving money before taxes on a 401, that is gaining me 25%. My retirement is currently at 21K, and even though I still have the credit card debt, retirement is a nice number to root for instead of against (like credit cards)
My suggestion depends on my interpretation of your company’s “10% match”. If that mean that they chip in $2 for every $1, up to 10% of your salary, then by all means you should be doing this as you are earning 200% on your money. Or even if it is a $1 for $1 match. But if they are only matching 10% of what you are actually contributing to the retirement plan, then it is a no brainer: retire the credit card debt first and foremost. Gaining 10% in a 401(k)match/investment doesn’t justify losing over $1000 a year in interest payments paying >28% on a balance of over $5000. That just doesn’t make sense. Yes compounding is great, but if you keep that debt you’ve got compounding working against you.
But I would recommended funding as soon as possible, and as much as possible, your investment strategies before retiring your student loan debt. This is generally good debt to have, under 7% interest (hopefully), and if you are an enterprising investor you can beat that return (whereas 28% is pretty darn hard to beat, especially with a 401(k) plan with limited investment vehicles).
Jonathan