Should I Pay Off Debt Before Contributing to a 401(k)?

Should I Pay Off Debt Before Contributing to a 401(k)?

July 02, 2019

This is a great question, and one that was recently asked of Dave Ramsey featured in an article for Fox News. You can see his full response here.

To summarize Dave’s response, he essentially says he supports taking a year or two away from contributing to a 401(k), if it means paying down or paying off debt. The reason? In Dave Ramsey’s opinion, building wealth is about 20% head knowledge, and 80% behavior-related.

This is interesting, and also somewhat insightful. There is a lot of power in paying off debt. Psychologically, paying off long-term debt gives individuals and families a boost and makes them feel like they are on the right track. It frees up some working capital to then allow you to save more than you could have before.

The important thing to remember, and what Dave Ramsey failed to address, is that not all debt is created equal. It is incredibly important to specify what type of debt should be focused on, and also to think about the consequences of focusing on paying down debt as opposed to saving towards retirement.

Just like paying down debt has positive psychological benefits, likewise seeing your retirement account build (in spite of the debt), can also provide a mental boost. Then the question becomes, which behavior is more important, building your savings or paying down debt? The answer to the question is that they go hand in hand.

Monetary wealth is quantified by subtracting debts from your assets, so your goal should be to focus on reducing one and building the other. The difference is, debt costs us money (interest) and saving can makes us money with interest or investment returns. 

Building Wealth in 2 Steps:

Step 1 in building wealth is to get into the wealth-building mindset and to establish healthy habits that encourage growth. Step 1 speaks to the behavior aspect. Self discipline is essential to accomplish step 1. If you are married, good communication with your spouse is also key to accomplishing this step. Looking at your monthly cash flow, identifying areas of opportunity, and making disciplined decisions daily is key. Your behavior or attitude towards money is important to understand in this step because it helps you to realize when you choose to spend or save and what triggers these choices. Check out more on money personalities here and find out what personality-type both you and your spouse identify with. 

Step 2 is to reduce or avoid costs. Costs come in the form of actual fees you pay, like interest on debt, or opportunity costs, such as missing out on an employer-match on a 401(k) contribution.

This brings us back to the original question: Should I pay off debt before contributing to a 401(k)? Our answer is, only if or when the cost is greatest.

In other words, if your employer matches your 401(k) contributions up to say 5% of your income dollar for dollar, then you are leaving a 100% return on the table for that contribution. The benefit of receiving dollar for dollar matching is greater than the interest rates you pay on debt. Credit card interest rates are high, but we aren’t aware of any 100% interest rate credit cards! To that point, once the 5% match is met, should you contribute more than that? Likely, if you have credit cards, your interest rate is higher on the credit cards than you can expect to receive in the form of interest if you are investing in the market through a 401(k). Therefore, in this scenario it would be better to pay down credit card debt before contributing additional funds to a 401(k). Chase after the highest costs in your life and reduce them.

One final point: if you know that you have a hard time staying out of debt, you can’t put off saving into your 401(k) until you are debt-free, if you won’t get there for another 10 years. It’s better to work on these goals simultaneously.

Building wealth doesn’t have to be complex. The thing we completely agree with Dave Ramsey on is, the answer to building wealth truly starts with your approach to building wealth, and your self discipline. Once you have this down, then you can start getting into the weeds to determine how to reduce hurdles you might face on your wealth-building journey!