Pay down debt or invest? Which is more important?
Continue to invest and pay down debt at the same time, says Klayman
By Alan Klayman | Published: October 15, 2008
Dear Maturing Loans,
I read your column about 401(k)s and CDs, and I was wondering two things. First, is this a good time to put money into a 401(k) plan? Second, should I be putting money into a 401(k) or paying down my credit card debt? -- Stu
Thanks for reading the column. Things are a bit confusing out there, so let's get to your questions and start to sort some of this out.
Is this a good time to put money into a 401(k) plan? The answer is yes. It is always a good time to put money away for the future. Where you invest the money is a secondary question.
You didn't exactly ask this, but I think you are inquiring as to whether this a good time to put money into stock mutual funds or the stock market, given the current market volatility and the dramatic drop we just saw. This really depends on your time frame. You have to expect that the market will go up and down, but the question you need to ask yourself is what is the time frame for when you will need to use the money?
If you need to use this money in less than five years, then you should have little to no exposure in the stock market. This goes for everyone who is taking minimum required distributions or who is living off of your retirement savings. Short-term money should not be in the stock market.
If you won't need the money until five or 10 years from now, then you can look at having some money in stocks or stock mutual funds. If you won't need the money until 10 years from now, then you can look at more of a stock-weighted portfolio. However, you must invest where you are comfortable, and now more than ever, you should seek the help of a financial professional.
Should you be putting money into a 401(k) or paying down your credit card debt? The answer is both. Let me explain: If you max out your 401(k) contributions, then you will be eligible for a tax deduction. You can then take the value of your tax deduction and use that money to pay down your debt!
How? I'll give you an example. Let's assume the following:
- You are eligible to put $10,000 away into your 401(k) plan.
- You have $2,000 in credit card debt.
- You are investing $3,000 in your 401(k) right now. You could put in more, but you are unsure of how the market will perform.
Using those assumptions, you can pay off some of your card balance while still investing in your 401(k) -- depending on exactly how much more you'd be willing to put in your 401(k).
If you can afford to contribute $6,000 a year toward your 401(k) and card debt, here's a solution:
- Put $5,000 into the 401(k). At a 20 percent tax rate, you will save $1,000 in taxes by making your 401(k) contribution. Take that $1,000 and pay down your credit card debt. To do this, you can either wait for your tax refund and apply it toward your credit card debt or take that amount of savings, divide it by the number of paychecks you get each year and apply that amount toward the debt.
- Now take the other $1,000 and pay down the rest of the debt.
Next year, take the interest savings that you would have paid toward your credit card balance and add it to your 401(k)!
Thanks for the question. See you back here next week.
See related: Know the rules before you tap your 401(k)
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