January 18, 2012

Getting a 401k Match vs Paying Off Credit Cards

On FreeMoneyFinance a little while ago a reader shared the story of their finances   They were currently working on paying down their credit card debts.  Paying off your credit cards is of course a very good idea.   However they were not saving anything for retirement in order to have more money to throw at the debt.

The thought occurred to me that they may be foregoing a 401k employer match in order to pay off credit cards.   That employer match is worth 100% of your money while paying off a credit card only saves you the 15-30% interest the credit card charges.  It doesn't make sense to give up getting 100% free money to save 15-30% interest for your dollar.

Better yet if you save money in your 401k then you can take a loan against that 401k money and use the loan to pay off your credit cards.   

Yet another bonus of saving money in retirement is the Savers Credit that you may be eligible for.   There is a tax credit for lower income earners such that you can get 10-50% tax credit on your first $2000 of retirement savings.  

Lets say you are married with $50,000 net income and you have $25,000 in credit card debts.   You have an extra $1000 at the start of the year from your IRS return.    You could either take that $1000 and pay down your credit card or use to to put towards your 401k savings.  Your employer matches your savings 100% up to the first 5%. 

Option A : pay down credit card and neglect retirement savings

You take your $1000 after tax dollars and put it towards your credit card debts.   This will save you 20% interest for the year.  At the same time you put $0 into your 401k.  

Net result = You save $200 in interest.  Net benefit $200.

Option B : save in your 401k, get a 100% match, then use 401k loan to pay off credit card

You contribute $1,333 to your 401k.  This will cut your tax bill by $333 due to the pre-tax nature of the money.   Your employer matches the $1,333 due to the 100% employer match.   You're in the 25% bracket so if you put $1,333 into a 401k in pre-tax dollars then thats equivalent to $1,000 in post tax money.
You now have $2,666  in the 401k between your $1,333 and the employer match.
The federal government will match your $1,333 due to the savers credit.  You get a $133 tax credit.   Take the $133 and pay down your credit card.  This leaves you with $867 on the credit card.
Take a $867 loan against the 401k and use that to pay off your credit card.

At the end of the year you'll have $2666 pre-tax balance in your 401k and a $867 loan against the 401k.

Lets say you had to cash out the 401k money to repay the 401k loan.   This would force you to pay 25% taxes and a 10% penalty.   You would need to cash out $1333 form the 401k to pay off that $867.   So we're now left with $1333 in the 401k account and the 401k loan paid off.

If you were desperate and had to cash out the entire 401k then you'd be left with $867 after the 25% taxes and the 10% penalty.   Net benefit $867.

In the end you'd be looking at Option A = $200 or Option B = $867.    

A few things to be aware of :

  • Your 401k loan could have fees associated with it that might make such borrowing a bad idea especially for smaller loan sums.
  • Some employers only match 25% or 50% of your 401k contributions.   In those cases paying down credit cards first might make better sense.
  • If at all possible you should certainly try to get a lower interest rate on your credit cards.   Paying 0% interest on a promotional credit card deal can help a lot.
  • The Savers Credit has specific rules and a income cap on it so only lower income households qualify.


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