Thursday, December 11, 2008

Paying Off Credit Card Debt Vs. Funding Your 401k

When we are presented with two options that both seem good, it can be tough to make a decision. This is true in the case of the choice between using extra money to pay off credit card debt or to invest in a 401k retirement program -- both of which are recommended by financial advisers.

In an ideal situation, it would be possible to both pay off credit card debt and contribute the maximum amount to an employer's 401k retirement fund. But for most of us, we have to make the most of a limited amount of money. So for Americans faced with the decision between paying off credit card debt and funding their 401k plan, how should we best put our money to work?

First, consider your credit card debt. According to the Federal Reserve, the average interest rate on credit card accounts is nearing 15%. That is very costly, especially since credit card interest payments are not tax-deductible. So with most credit cards charging 15% interest on whatever balance is owed, paying off credit card debt is equal to earning a guaranteed 15% return on your money.

Next, consider your 401k plan. Many employers will contribute $0.50 for every dollar you put into the plan, for a guaranteed 50% return on your investment. Additionally, the money you invest in your 401k plan grows tax-free until you take it out. That is a major difference from the money used on a credit card, which gets no special tax treatment.

Based on this logic, it looks like the 401k, with its tax-advantaged 50% return, trumps paying off your credit card debt and its regular "return" of 15%. However, when you consider that a 50% employer match on your 401k investment is a one-time deal, while 15% interest on a credit card balance in ongoing, it becomes clear that you should first pay off the credit card debt.

But in order for the math to work in your favor, after paying off the credit card debt, you have to make sure not to run up a balance again in the future. Additionally, once you have erased your credit card debt, you should contribute the full amount to your 401k.

It is almost always a good idea to avoid carrying a credit card balance. But what if you feel you should begin contributing to your 401k immediately, and therefore have to revolve a credit card balance to do so? Could this be a better option for you than paying down your entire credit card balance first?

To do the math, imagine you have $150 each month in extra money as well as a $4,000 credit card balance racking up 15% interest. In this case, the minimum credit card payment each month would be about $90.

If you choose to first get rid of your credit card debt, by using the full $150 each month to pay down your balance, you could eliminate the credit card debt in 32 months at a cost of $756 in total interest. After your credit card balance had been reduced to zero, you could then invest the entire $150 into your 401k each month. With an employer match of 50% and an annual 8% return, your 401k would reach $5,410 in 54 months -- the same time frame we will consider below.

However, if you decide to begin contributing immediately to your 401k, putting $100 a month toward paying off your credit card debt and the other $50 into your retirement plan, it will take those 54 months to eliminate your credit card debt at a cost of $1,341 in interest. With the employer match and an 8% annual return, you would have $4,890.

By first paying off your credit card debt, it would be erased almost two years sooner than by trying to use money for both the debt and the 401k simultaneously. Meanwhile, your 401k would grow by an additional $500 over the 54 months. Therefore, paying off your credit card debt first, then investing fully in your 401k, wins out.

Of course, since a credit card bill is paid with after-tax dollars while a 401k is funded with pretax dollars, a truly real-world comparison must include the impact from taxes.

As an example, if you are in the 25% federal tax bracket, you need to earn $200 to net $150 after taxes to pay off your credit card debt. But if you decide to tackle the debt while also investing in the 401k as outlined above, you need to earn just $183 for the $100 after taxes and the $50 pretax. The difference could then be also invested in your retirement account.

Using this approach of both paying down the credit card debt and investing in the 401k, you would have $6,508 at the end of the multitasking period. But if you first paid off your credit card debt, you would then have more to contribute to a 401k, which would in turn yield $7,188.

Therefore, when given the option, it makes financial sense to first tackle your credit card debt completely before then moving on to contribute the maximum amount to your 401k plan. One way to quickly reduce credit card interest payments (which can save you both time and money) is to apply for a balance transfer credit card with a lower APR than the credit card you are currently using. Lower interest rates mean smaller credit card bills, which in turn mean less time paying off a credit card balance and an earlier start contributing to a 401k.

In closing, to truly make the most of your money, employ good financial behavior. Always pay off your credit card balance, and be sure to take advantage of a 401k plan that offers an employer match.

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