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Retirement Savings vs. Debt Reduction

I’m on a mission.  I am committed to helping as many people as will listen to become free from the restraint, risk and ridiculousness of the burden of debt.  In that mission, I sometimes get carried away and have to remind myself of the real priorities in life.  I sometimes struggle to be generous.  I often struggle with being cheap.  I sometimes struggle to pay someone else to do something I could maybe do myself, even if it would take me 30 times longer and in our current schedule there isn’t a spare second.  I sometimes secretly think, “Does Stacy really need to go grocery shopping or could we save that money toward retirement, allowing me to retire a couple weeks earlier?”  Okay, maybe I’m not that bad, but you see my point – when we are on a mission to get out of debt or save like crazy toward a goal, we sometimes get TOO FOCUSED.  This often leads to bad decisions or imbalanced priorities.  That’s what I want to talk about today – balance and priorities.  Since that could be a book, I’m going to narrow my focus for today a bit to talk about the balance between long-term savings (especially for retirement) vs. focused debt reduction.
Once I’ve gained a new convert to the “debt is bad, I want out” philosophy, the obvious question is, “how can I get out the fastest and what’s the best approach?”  Included in that stream of thought is the idea of selling off some things and/or dramatically changing priorities to maximize the ability to pay down debt.  One common set of questions is, “Should I stop paying into retirement while I’m paying off debt?” and, “Should I cash out any of my 401k to pay off debt?”  Let’s address both of those questions.

Should I stop paying into retirement while I’m paying off debt?

The answer: MAYBE.  Dave Ramsey’s advice is to stop paying into retirement while paying off your debt (except the mortgage).  From his newsletter in February of 2011, he specifically answered this question as follows:

You want to commit all your energy and resources to getting out of debt…and diverting money toward retirement savings means you’ll stay in debt longer. Don’t dilute your efforts; concentrate on one thing at a time. Even if you get a company match, don’t take it while you’re eliminating your debts. With a cut lifestyle, extra income from a second job (if you take one) and super focus, you’ll get out of debt quickly and establish your full emergency fund. Then you can go right back to investing. Being debt-free will more than make up for taking a year or two off of investing.

I agree with his point with a couple of exceptions*.  First, if the math of your situation already works (income – expenses = something left over to pay toward debt) and you have room to cut expenses or do other things to give you the needed leverage to pay off debt quickly, I say you should do everything on that side before you consider unplugging your retirement savings.  Why?  Most companies match dollar for dollar, meaning you get 100% return on your investment in the first year.  That is FREE MONEY.  Even if you have credit cards at 29% interest, you still come out 71% ahead (okay nerds, I know I simplified the compounding math – cut me some slack).

Second, if you unplug your retirement before you’ve done everything to straighten up your financial behavior; you are simply giving yourself more income to use to misbehave!  Think about it – if you stop saving for retirement and thus bring that extra income home but haven’t decided to behave with it, you may just go on a shopping spree instead of paying off debt. If you can learn to look at your debt as an enemy standing between you and freedom, you can change your attitude and behavior.  That’s the top priority.

Should I cash out any of my 401k to pay off debt?

The answer: ALMOST NEVER!  If you decide you want all your debt gone and have the determination to make it happen, you’ll be looking to squeeze every last penny out of your budget to kill debt.  If you’ve built up some retirement savings, you’re treading on dangerous ground to touch it for any reason.  Why? Let’s look at the math.  If you cash out a 401k or similar retirement plan, you’ll have to pay taxes on that because the government is going to treat it as income (this means you’ll pay 15-28% to the IRS), plus any state income taxes you may have to pay, plus a 10% early withdrawal penalty.  In other words, you might have to give up 40% or more of what you withdraw just to cover taxes and penalties.  Even worse, that math doesn’t consider the damage to your retirement accounts and trust me; you want those to be big numbers when you reach retirement age.  That is…unless you always want to work.

*On all these points I assume you’re already contributing to your 401k, 403b, 457, etc. up to the amount matched.  If you’re contributing more, bring it down to ONLY the amount of the match.  If you’re not contributing, don’t start until after you’ve killed your debt.
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