Dave Ramsey in his Financial Peace University class advocates that in order for people to pay off their non-mortgage debt like credit cards, car and student loans, that they should get the Gazelle mentality: temporarily cut back on all expenses, get second jobs, and stop funding their 401k and devote all disposable income to repaying all debt as soon as possible.
However, a lot of people ask 2 questions: “we have funded our $1,000 emergency fund (Ramsey’s Baby Step #1), and have debt to yet to re-pay. Should we forego all of our 401k contributions, and miss out on the employer match? Secondly after we have paid off all of our debt, and begin to fund our 3 – 6 months of emergency savings, wouldn’t it make more sense to resume funding our 401k that provides a nice company match (which equates to an instant 100% return) and invest it in the 401k plan’s mutual funds, instead of a savings account that earns hardly anything.”
Debt is bondage, and the sooner the better for getting out of debt; so that people can enjoy the freedom of being debt free. There is also a behavioral angle, even though it might make more sense to keep contributing to the 401k mathematically, some people might not be able to stay on track to becoming debt free as easily if they don’t stop the 401k. This makes sense, however I think it also is important to analyze the mathematical outcome, so that someone can make an informed decision. How do you analyze this? The actual calculation is complex, because you have to take into consideration such things as taxes, rates of return, debt interest rates, time-value of money, and long-term accumulations on the 401k. I don’t know of any software that will run this, shy of buying incredibly complex cash-flow software. However, I think you can still make an educated estimate. Start by first running 2 debt-snowball analyses; one with the amount that would have gone into the 401k and one without it. Comparing the two will show you how many years it takes to be debt free, how much money you would save if you didn’t wait, and when you can resume funding the 401k. Then calculate how much the employee’s and employer contribution into the 401k would have been had you stopped funding the 401k, plus the growth on the money you expect to have. For one individual I ran the analysis for, if he would have funded the 401k instead, the difference in interest savings on the debt versus accumulation in the 401k was about 1,600 more in the 401k in 5 years. This does not take into consideration the lost income tax savings of not funding the 401k or the long-term accumulation on the 401k. Also, for this person the debt amount was very large (over $100,000), and the loans were mainly low-interest rate student loans. This kind of analysis is just a start, the individual should also examine their tax situation and talk to any other financial advisors that you may have before making a decision.
The second question, is should we fund the 3 – 6 months of emergency savings (Baby Step #3) that earns no interest, and wait to fund the 401k? Financial Planners recommend putting savings into accounts that are low risk and easy to get to like Money Market Accounts, for emergencies like long-term job loss, even though it earns hardly any interest. If you take money out of the 401k there will be income tax + 10% pre-59/12 tax penalty (sometimes waived if hardship), the other risk is pulling money out the 401k might occur during an inconvenient time when the market is down, and experience an investment loss. Some 401k plans though provide access to some of the funds without penalties, through loans if you are working for the employer that provided the 401k.
