To 401(k) Or Not To 401(k)

401k.jpg

As many of you know, I have the utmost respect for Dave Ramsey, and the methods he teaches for financial freedom. And while there’s no doubt that his system works, I find that managing your money based on principles alone, without testing the financial implications of those principles, can lead to incorrect decisions, at least in my view.

One principle taught by Mr. Ramsey, is to pay off your debt first, before investing in your retirement, such as a 401(k). Dave will assert that, after your done paying off your debt, you can then “more than make up for lost time”, by directing the former debt payments to your retirement account. But is that always the case? Does it make sense for you to stop investing in your 401(k) now, and use that money to pay off a car loan, student loan or credit card?

My answer is no. Not in every case.

Consider the example of a couple who earns $8,000 per month, makes $400 per month in 401(k) contributions, and works for an employer who contributes up to 4% in their 401(k), but only if they also contribute that much (also called the 1-for-1 up to 4% match). They just bought a new car, and borrowed $20,000 on it for 5 years at 5% interest, which means they will be making payments of $377 per month. And their question is, should we stop contributing $400 per month to our 401(k), and use that money to make extra payments on the car loan, to pay it off faster, and save some interest expense?

To recap:

  • Monthly gross income = $8,000

  • 401(k) contribution = $400 (5%)

  • Employer match = $320 (4%)

  • Income tax bracket (married filing jointly) = 22%

  • Car loan = $20,000

  • Loan payment = $377 per month

Using amortization tables available on the internet (such as the one available here), will tell you that the interest paid over 5 years is $2,646. If the couple stops contributing $400 per month to their 401(k), and instead makes additional $400 per month payments on their car loan, the 60 months loan is paid off in 28 months, and the interest paid is only $1,200, for a savings of $1,446. Sounds like a winner, but hold on.

By foregoing their 401(k) payments, they also lost out on their employer’s contribution of $320 per month. Over 27 months (the 28th payment was less than $377), that’s $8,640. Ouch! Also, less significant but no less important, by stopping their contributions, their taxable income increased by $400 per month, increasing their taxes by $88 per month (remember, they’re in a 22% tax bracket). Over 27 months, that’s $2,376.

At this point you may be saying, “wait a minute, if this couple follows Dave’s advice, and stops contributing to their 401(k) so they can pay off their car loan faster, it will cost them over $11,000, for interest savings on the car loan of only $1,446? Is that what you’re telling me?”

Yes, that’s exactly what I’m telling you.

And the concept of “making up for lost time after the debt is paid off” also doesn’t work in this case, because their employer’s contribution, $8,640, is gone forever, there’s no way to get that back.

I think what Dave recommends, to pay off debt as fast as possible, is still very sound advice. And to that I would add, use your 401(k) contributions only as a last resort. Reason being that, like in the example, if you don’t contribute your employer won’t either, and you are simply “leaving money on the table” - walking away from significant additional pay from your employer, for very little benefit.

Figuring this stuff out on your own can be difficult. The good news is, you’re not alone! These are the kinds of questions that JB WAGG INC Daily Money Managers help answer for our clients, every day. We are certified by the American Association of Daily Money Managers (AADMM), and if you would like help with this or other matters related to daily money management, send me an email at robert@bangforyourbuck.org. We would be happy to help you!