Which "Top Priority" Is Really No. 1?
Paying off credit cards and funding a 401(k) are both good ideas. But you can't put money in two places at once.
(MONEY Magazine) - At my age--at any age, probably--you hear a lot of sentences that begin, "The most important thing to do with your money right now is...." They can't all really be the most important, but certain moves can pay off more at certain times in your life. The two I'm hearing most about right now are "feed your 401(k)" and "pay off credit cards."
Both of these, I know, are terrific ideas. After all, I've read my employer's big packet of 401(k) information, which came filled with exhortations to get on the stick because the more you save early on, the more you'll end up with, and not taking advantage of matching funds is like throwing money away, blah blah blah. As for credit cards, I'm well aware--and would be even if everyone from my father to this magazine weren't telling me so--that paying them off quickly saves you from being charged hundreds of dollars over the original price on your TV or plane ticket, emancipates you from the shackles of high finance charges and frees you to enjoy the glories of home ownership, investing and other heretofore (at least to me) unimaginable luxuries.
So, um, which of these extremely important goals should I lick first? I ran some numbers with the help of several financial planners, and I was surprised by the passion on both sides of the answer. In the end, though, the winning move became clear: Pay some money toward the debt and some toward the 401(k).
First, the Numbers
Doing the math is like watching a good thriller: It leads you down a complex path, then hits you with a surprise ending. Stay with me here. Say you owe $4,000 on a credit card that charges 15% interest. After your monthly expenses, you have $150 to put toward your debt, your 401(k) or both. The minimum payment on the card would be about $90 a month. If you put $100 toward that and the other $50 into your 401(k)--call this the multitask scenario--it would take you 54 months to erase the debt and you'd have paid $1,341 in interest. As for your 401(k), assuming a 50% match from your employer and an 8% annual return, you'd have $4,890.
But if you opted instead for the "one at a time scenario" and put the whole $150 toward your credit card, you'd pay off your debt in 32 months--nearly two years sooner--and shell out just $756 in interest. Once the decks were clear, you could put the whole $150 into your 401(k), which (including the match) would grow to $5,410 after 54 months, or about $500 more than with multitasking. Making bigger contributions for a shorter time trumps an early start.
To make a truly accurate comparison, however, you have to consider taxes, because you fund your 401(k) with pretax dollars but pay your credit-card bill with after-tax dollars. If you're in the 25% federal tax bracket, for instance, you'd have to earn $200 to net $150 after taxes to pay toward your debt but only $183 to get $100 after taxes for the debt and $50 pretax for the 401(k). If you treated the difference as found money that you slip right into your retirement account, your 401(k) would be worth $6,508 by the end of the multitasking period. Of course, once you'd paid off your card under the one-at-a-time scenario, you'd also be able to contribute more to your 401(k), bringing it to $7,188. Paying the credit card first wins again.
The Scale Tipper
Here comes the surprise ending. After all this sophisticated arithmetic, the difference between the two scenarios boils down to less than $200 a year. Should you really base this decision on such a paltry sum? Or is getting into the habit of saving the more important consideration? "Usually, when a client comes with this question, I don't even run the numbers up front," says Aaron Coates, a financial planner at Compass Wealth Advisors in Elkhart, Ind. and co-founder of NextGen, a group of financial planners 36 and under. "I assess where the person is behaviorally."
In this case, treating your 401(k) as a luxury you can indulge only after taking care of every other priority is too risky. Sure, credit-card debt is bad. It has a sneaky way of leading to more debt--the fatal "Hey, what's another hundred bucks?" argument--and it should be erased as soon as possible. But that's all the more reason to get started saving too. After all, you don't want to walk into the clubhouse after a golf game one day when you're old and gray and have to put your post-game hamburger on a credit card because you didn't save enough for retirement.