Should I Stop Contributing to My 401k to Pay Off Debt?

by RC on April 9, 2008

I recently was faced with a decision that I believe many people have faced while trying to get out of debt. In an effort to pay off debt as quickly as possible, one would obviously like to direct as much money as possible towards debt repayments. Cutting back on luxuries or items you consider frivolous to start your debt snowball is not necessarily that difficult a decision to make, but you have to be determined to cut back in those areas. However, one category where the decision can be difficult and not really clear-cut is whether one should stop making contributions to your retirement plan, either a 401k, 403b, or other retirement savings vehicle in order to free up more money for debt repayment. I think there are several factors which can come into play when deciding which option is right for you.

  • Age- I am in my mid-thirties, and while I have a strong desire to become debt free as soon as possible, my retirement age is getting closer and closer. By stopping my contributions, I am basically delaying my retirement. On the other hand, the younger you are, the longer you can contribute to your retirement savings, so stopping for a short period of time to pay off high interest debt may not hurt you too bad.
  • Whether your employer offers matching contributions- If your employer offers matching contributions and you stop contributing to your 401k, you are leaving free money on the table. Many employers match the first few percent of your salary that you contribute, or match 50% of your contributions up to a certain percent, which is what mine does.
  • How much debt you have and when you expect to pay it off-I looked at the time-line I have set up for paying off my debt, and I hope to have it paid off by the end of the year, even with contributing to my 401k. However, I could shave several months off this time frame if I stopped my 401k contributions. If the time frame were longer, I might consider stopping my contributions to shorten that period of time.

For me, after I though about it for a while, I decided it did not make financial sense to stop my 401k contributions completely, nor would I feel very comfortable doing so. I would be missing out on my employer match, which is 50% for the first 5% I put in. None of my CC debt has a higher interest rate than 50% , so what I am doing now is to put in the amount up to my employer match. If my employer did not make matching contributions, I would have to think really hard about whether or not I would stop making contributions, and I have a feeling I might do so. But the automatic 50% return is too good for me to pass up.

One thing this dilemma has inspired me to do is to try to pay off my credit card debt as fast as possible, and focus on earning more and spending less in order to speed up the process. What are your thoughts on this issue?



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{ 19 comments… read them below or add one }

brainy April 9, 2008 at 9:12 am

Hmmm… I think in that situation, if you’re really keen on paying off the debt at an accelerated pace, I’d drop my 401k contributions down to the 5% you mentioned that will get the 50% match…

Even doing that for a few months could be enough to get a jump on the debts and then you can increase the contributions again (even before the last of the debt is paid off).

I kinda did that sort of thing, lowered my contribution, knocked off a large chunk of debt as a result, then increased the contribution higher than I ever had while slowly knocking down the last of the debt… except this time, I had some momentum, so even at a slower pace, it went quickly.

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RC April 9, 2008 at 9:51 pm

Brainy:

Good point, that is basically what I have ended up doing for now. I am hoping to increase my contribution higher than I ever has it as well when I get the CC debt knocked out.

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AndyS April 14, 2008 at 1:57 pm

Good choice. The other you could consider is to take a 401K loan and use that yo pay off your credit card. Like most of us your 401K returns are probably pretty lousy at the moment. Make sure to pay off your loan though within 90 days to avoid the 10% penalty.

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RC April 15, 2008 at 9:48 pm

@Andy:
Yes, that is an alternative as well, but I am not sure if i trust myself!!

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Shawn September 16, 2008 at 9:58 am

Lowering contributions into your 401k-plan is ideal in order to accelerate your debt repayment. However, there is one element to your debt that you have missed. If the debt is your credit card the average credit card debt is 15% and continues each month until your debt is repaid, whereas the 50% company match is a one-time deal for the contribution. One way to make that decision is to take the amount of interest you will have to pay over the expected payoff period for your debt and compare it to how much money you will earn in interest over the same period for the 50% contribution amount. Most often the money lost by not investing in the 401k-plan and the company match is less than the interest paid at 15% and therefore would make it logical to stop the contribution to pay the debt off faster. Other wise your paying more in interest then you are earning in your 401k plan. The other portion of debt payoff is to make up the lost investments. Once the debt is paid off the monthly income used to pay off the debt should then be added to the 401k-plan on top of the regular contribution amount. I have heard a good investment number is 15% of gross pay, but only after the debts are paid off.

This only makes sense if the credit cards are cut up and never used again, and there is a drive to be debt free.

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RC September 17, 2008 at 8:19 pm

@Shawn- What you say definitely makes sense-one should look at the total amount over the expected payoff period, and one can make up contributions (assuming they are not maxing out) and get a match on that later.

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Dane October 8, 2008 at 12:32 am

What to do!
By Anonymous (Male)
It appears that the “Burden” has been placed on the American Taxpayer yet again! Unemployment is up, our retirement accounts have VANISHED (2 Trillion dollar lose thus far). Yet the persons responsible (CEO’s) walk with millions of dollars in pay as Golden Parachutes. AMERICAN TAXPAYERS MUST BE HEARD and NOW IS THE TIME! This message will be heard by doing the following;

1) STOP INVESTING IN YOUR 401K (do this at the LEAST!)
2) Move your 401k OUT OF THE STOCK MARKET.
2) DO NOT INVEST IN THE STOCK MARKET.

Let us be heard that we will not sit idly by, while our government TAKES 700 BILLION DOLLARS OUT OF OUR POCKETS and FUTURE GENERATIONS POCKETS!

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Jason October 10, 2008 at 2:39 pm

How large is the credit debt? Consider taking a loan out from your 401K to pay off or pay down this debt. Sounds crazy, but consider you would still be able to contribute with matching, AND pay back the debt + interest. The caveat of this, however, is the interest would be paid back to YOU and your 401K and not to some faceless bank/credit institution. I did this to pay off a couple of relatively low balance credit cards, which were charging me about 5% interest. I took a loan out and am now paying 7% on the loan, but that 7% is now interest being paid to me!

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RC October 10, 2008 at 10:02 pm

Unfortunately, it is pretty high, in the low 5 figures. I have thought about it, but with the large losses my 401k has taken, I think I am going to stick with trying to pay it down aggressively. But I do not think a 401k loan is as bad as some people do- it seems to have worked out pretty well for you so far.

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Tom Steele November 15, 2008 at 3:22 pm

I’ve been thinking about this as well.

What is wrong with this math?

You contribute 5% to your 401(k). Your employer matches it with 50 cents on the dollar.

Let’s make it easy and say you make 100k per year.

So you are contributing 5k per year. Your employer is matching with 2.5k per year. (I love this font!)

That is $7,500 per year that you are receiving, but you are putting in only $5,000 to get that money.

Now, if you cash it all out at the end of the year, you will collect $7,500 – 10% (750) = $6,750. You must pay income tax on this money now at your current rate.

However, no matter how you slice and dice it, you come out ahead putting into the 401(k).

Of course there is one caveat. If your 401(k) dropped during the year then this doesn’t work so well. But if you KNEW it was going to drop, you shouldn’t have put in at all, and we can never KNOW or we’d be so rich we wouldn’t need a 401(k) – right?

Depending on your plan rules, ideally you should contribute the max your employer matches, then take it out immediately after each paycheck.

Then you would be GUARANTEED a gain of 35% – right?

Please feel to correct me on what I’m missing if anyone sees something…

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Mike January 28, 2009 at 1:57 pm

My employer just eliminated our company’s 401K match. That gave me the green light to reduce my contributions to 1% & use the money for my debt snowball. Initially was planning to stop all contributions to my 401K, but I would have to stop the plan & then restart at the next window. The convenience to immediately increase my 401K in the future was worth the 1% I was giving up paying off my debt.

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RC January 28, 2009 at 11:00 pm

@Mike-sounds like a good idea to me- I think keeping the 1% so you don’t have to wait when you restart is a good idea also- Good luck!

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edh February 24, 2009 at 12:32 pm

how does this affect your taxes bc your take home pay will be higher. now you are getting taxed on the money you would have been putting into the 401k. this makes me wonder how worthwhile it is. i am planning to reduce to the amout my company matches. but then i have to take into account i am not really getting the full amount. fyi, my debt is mortgage and HELOC if that makes any difference.

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RC February 25, 2009 at 11:36 pm

@edh- One thing to keep in my is that your 401k contributions are not tax-free but tax-deferred, which means you would pay taxes on your contributions and earned interest when you reach retirement age and started withdrawals. It would depend on what tax bracket you are in then compared to now of course. if you are in a lower bracket then than now, you could be paying more taxes.
Also, as you mention, you will not get the full amount of the contributions as you are being taxed on that money now if you reduce your contributions.
Depending on the amount and the interest rate on your mortgage, but more likely the HELOC, it may be a wise choice to try to pay down the HELOC.
It is probably a good idea to continue to contribute the amount for the company match, though.
Hope this helps!

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ITguy March 4, 2009 at 11:40 am

Not only has my company eliminated my 401k match but they also took 3.5% of my pay a week ago. I’m at a point where if you look at how much money has been contributed is 20% higher then it’s current value.

I don’t want to stop contributing because I do believe that things will get better at some point in time but with the pay cut I kinda need the money that I lost since my pay cut. Would it be that bad to just lower my contribution as much as possible to help get through losing a percentage of my pay? That extra money help me get 80% out of credit card debt with but I still have some left that I am really wanting to get paid off but no longer can afford to make the larger payments that I was.

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Mark December 4, 2009 at 11:57 am

@Tom Steele

Your math is correct but you cannot take a 401k “distribution” if you are still employed by the company. You can take a loan on the money but you have to pay it back.

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Bdubs January 7, 2011 at 11:24 am

Thank you for this article. This makes me feel better about reducing my 401K contribution to 1% for now. I still contribute a little, but I’m focusing on my debt. My employer stopped 401K matching, so it made more sense to pay off debt. I’m in my late 20s and hope to be out of debt by 30. Then I can bump up my contribution again. Good luck with your retirement!

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Pete February 23, 2011 at 9:54 pm

I think that you should contribute to your 401k consistently, even during the debt reduction process. Debt reduction is about making up for lost time, and the best way to do this is to let compounding interest (time) in a 401k lead the way. http://www.petetheplanner.com/blog/2011/02/24/contributing-to-your-401k-when-you-are-in-debt/

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Jim December 6, 2011 at 6:54 am

One other thing to think about: the money you invest in your 401k is tax deferred. Don’t put it in and you pay taxes on it, diminishing how much you invest. Even if the stock market is not doing well now, view that as an opportunity to buy more shares (i.e., buy low, sell high). This is a great buying opportunity, don’t miss it. However, if your debt is killing you, it’s always a good thing to be debt free.

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