07 Jan Should I stop 401(k) savings to pay off credit card debt?
Q. I have been working to pay down my credit card debt and there’s only about $10,000 remaining. I have always fully funded my 401(k) but I’m wondering if for next year, just to get rid of the debt faster, if I should stop contributions. What are the pros and cons?
A. We’re glad to hear that you’re tackling these two very important financial goals — saving for retirement and reducing credit card debt.
The hard part comes in choosing between them, as your question proposes, because the time horizon, relative urgency and ultimate importance of the two goals differ so greatly.
Let’s start with the credit card debt.
Depending on your credit score and the type of cards you hold, your average interest rate is likely to be in the 15 to 20% or more range, which means that you are paying an annual interest cost of $1,500 to $2,000 or more on your $10,000 of debt, none of which is tax deductible, said Gene McGovern, a certified financial planner with McGovern Financial Advisors in Westfield.
He said with savings accounts and money market funds currently yielding only 2 to 3% — if you’re lucky — paying down your credit card debt is a smart investment and one of the best uses for short-term funds. It’s equivalent to receiving a guaranteed 15 to 20% return on your money, he said.
On the other hand, funding retirement is usually by far the single largest financial goal any of us faces, dwarfing most other expenses.
He offered this simple example to put the numbers in perspective.
Assume, for example, that your retirement is 20 years away, and that you’ll live another 25 years in retirement. Also assume that you can earn an average return of 5% on your invested retirement funds. You estimate that your retirement living expenses, including taxes, will be about $5,000 per month in current dollars, or $60,000 per year, and that inflation will average 2% a year over the entire period.
Let’s also assume that your monthly Social Security benefit when you retire, in today’s dollars, is $2,000, or $24,000 per year.
Net of Social Security, then, you’ll need about $3,000 per month ($5,000 – $2,000), or $36,000 per year, McGovern said.
With 2% annual inflation, you’ll need more than $53,000 per year, or about $4,460 per month net of Social Security, at retirement 20 years from now.
To fund 25 years of retirement, with your living expenses increasing each year at the rate of inflation, you’d need to have accumulated about $965,000 by the date you retire.
In other words, your retirement need in this example is nearly 97 times greater than your $10,000 credit card debt.
“Given the cost of funding retirement, it’s usually not a good idea to stop funding your 401(k) plan to address short-term needs,” McGovern said. “That’s especially true if you’re otherwise able to pay down the credit card debt, although more slowly, without shortchanging your 401(k) contributions.”
Moreover, he said, if your employer makes matching contributions to your 401(k) plan, you’d be missing out on an immediate 100% return on your matched contribution amounts.
Also consider also the power of compounding.
Albert Einstein is reported to have said that “the most powerful force in the universe is compound interest,” McGovern said. To take full advantage of that power, though, you need lots of time.
He offered this example of why.
Let’s assume that you’re a diligent saver and you put aside $12,000 per year, with an eye to retiring at age 65. Also assume that your salary increases by 3% per year, and that you increase your retirement contributions by that same percentage each year, while earning an average 5% on your investments.
If you begin saving at age 25, you’ll have nearly $2.3 million at retirement.
If you don’t start until age 35, you’ll have just over $1.1 million.
If you wait until age 45 to begin, you’ll have only $508,000.
“In short, compounding needs time to work its magic,” he said. “That’s another great reason to start saving early and not to shortchange your retirement savings now.”
In the end, McGovern said, your best course is probably to review your budget and determine how you can spend less than you take home. That will help you to steer clear of amassing any further credit card debt while keeping you on the road to a secure retirement.
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This story was originally published on Jan. 7, 2020.
NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.