Just because there is threat of a recession, the stock market is gyrating, and the U.S. is being lambasted with negative press across the globe concerning our national debt does not mean it is a good time to back off your retirement savings. In fact, it could be the worst time. We heard these concerns loud and clear in 2008 when the market dropped nearly 40%. Employees calling into our financial helpline asked our financial planners in frustration, “Why should I invest in my retirement plan when I am losing money every single day?” First-time investors stopped their contributions because they saw their statements and it appeared their contributions were simply disappearing. It turns out those investors who held firm to their long-term strategy of investing each month regardless of the current market were able to reap the benefits of the rebound.
There are, however, legitimate times when not investing in the 401(k) may be the best financial strategy—not because the market is down, but because there is another urgent competing priority that, unless handled, would damage the ability to retire. Employees who say they are not on track to retire tell us that retirement planning is their top financial priority followed closely by getting out of debt. Unless addressed, high interest credit card and consumer debt can derail attempts to reach retirement goals.
In general, when the cost to borrow exceeds the opportunity for growth, it makes more financial sense to pay off the debt first. When the opportunity for growth exceeds the cost to borrow, the opposite is true. There is an exception to this general rule, and that is when the 401(k) offers matching contributions. Matching contributions represent an immediate return on investment. For example, receiving a 50% matching contribution is the equivalent to earning a 50% rate of return instantly. When matching funds are available, it usually makes sense to capture those first by contributing to the 401(k) up to the full amount matched by the plan. The question then becomes whether or not to contribute unmatched funds to the 401(k).
The argument for not investing in a 401(k) stems from the possibility that the cost for servicing high-interest debt may outweigh the potential performance on retirement plan assets. Consider this simple example. If a 401(k) participant earns 8% on a $10,000 investment, but at the same time pays 14% interest on a $10,000 average credit card balance, what is the net result after one year? The investor would earn $800 in their 401(k), but it would cost them $1,400 in interest payments. Over the course of 30 years, the $10,000 investment would grow to over $100,000, but if the investor maintains the average $10,000 credit card balance it could cost over $40,000 in credit card interest payments. What if instead the investor used the $10,000 to pay off their credit card debt? Not only would they save over $40,000 in interest, but the $1,400 in annual interest payments could be invested in the 401(k). Compounded annually at 8%, this would grow to over $158,000 in 30 years. The greater the spread between the high-interest debt and the rate of return on investment, the greater the financial advantage for paying off the debt first.
How to get out of debt quickly
Step one – Stop using your credit cards. This step may appear obvious, but many people bypass it, focusing instead on the more sophisticated financial components of debt reduction. In order to get and stay out of debt, you first need to live within your means. Once you are able to do this, work toward living below your means so that you are able to build up an emergency reserve and eventually start making extra payments to your lenders.
Step two – Find money in your budget. Look back over a few months’ expenses to determine where you are spending your money. Using a manual spreadsheet like the expense tracker or an online program like Mint.com or Quicken can help you track your cash flow and look for ways to cut spending. You may also want to temporarily suspend unmatched contributions to your 401(k) plan.
Step three – Build your emergency reserve. This might be counterintuitive because savings accounts pay virtually nothing and credit card interest rates are so high, but similar to the question, “which came first, the chicken or the egg?,” an emergency fund is an integral part of getting out of debt. One emergency will sidetrack step one and force the use of credit cards for the unplanned expense. Build up at the very minimum at least a couple of month’s worth of expenses in a liquid account before tackling the debt problem. Don’t forget to count the principal in your Roth IRA as part of your emergency fund since the IRS allows withdrawals of principal without incurring taxes or penalties. Set up an automatic transfer from your checking account to your savings account every month so the emergency fund gets replenished when the funds are used.
Step four – Start with the debt that is hurting you the most. Make a list of your credit cards and loans, not by balance, but by interest rate with the highest one at the top of the page. (For a debt inventory, click here.) Pay the minimum on each of the other cards but pay the extra funds toward the one with the highest rate until it is paid off. Once that card is paid off, take the total amount you were paying and add it to the minimum you are paying on the next loan on the list. This system is the fastest way to pay down your debts; we call it the DebtBlaster strategy but it has also been called the snow ball and the avalanche. (For a calculator to determine how many months it will take to pay off all your debt, click here.)
Step five – Take a second look and make deeper cuts. Take a lesson from the extreme retirement savers (who strive to live on 25% of their income in order to save 75%) and drastically reduce your expenses in order to pay off your debt sooner. Take a hard look at your expenses to see where you can cut even deeper. Ask yourself if you can reduce your biggest expenses by living in a much smaller place, reducing transportation costs by getting rid of a vehicle, and eat “in” instead of “out.” Consider being extreme at least for a short time period because the sooner you pay off debt, the more interest you save and the sooner you can fund your retirement.
Sometimes a step back is ultimately a step forward as long as that step is taking you in the right direction. To simply react to a volatile market by stopping contributions or rashly moving funds to cash may actually hurt more in the long term. We may be in store for more difficult times ahead so following a well planned strategy with thoughtful choices will help investors stay on track.
Liz Davidson is CEO of Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff Certified Financial Planner™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.
