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Should You Pay Off Credit Card Debt or Contribute to a 401(k)?

Should you start saving for retirement with a 401(k) before paying off credit card debt? It depends on your situation, but for most people the answer is…

Here’s a question I get all the time:

“When I become eligible for a 401(k) or another tax-deferred retirement plan, should I contribute to the plan even if I could use those funds to pay down credit card debt?”

Most of the time, yes.

The exception is if you have a big load of credit card debt with APRs over 10 percent. But if you’re paying off student loans at 8 or 9 percent or a car loan, that’s no reason not to begin funneling some savings automatically to retirement account.

Few things are more important than paying off credit card debt as quickly as possible to avoid throwing money away on the exorbitant finance charges, so it seems starting a retirement plan would be out of the question until your debts are gone. But human beings are not robots, and the psychological benefits of getting into the habit of saving and watching your investment grow are important.

Remember also the financial benefits of starting a 401(k):

Compounding Interest –– They say a dollar invested when you are 25 is worth two, or five, or even ten invested when you are 40. The longer you wait to start saving for retirement, the more you have to contribute annually to achieve the same results. Even with large balances on high interest credit cards – assuming you can still maximize your payments to rid yourself of these debts as quickly as possible, the 6% or so of your salary will be well saved in your retirement plan.

Employee Matching –– Many, but unfortunately not all, employers will match all or a portion of your annual retirement contribution. Most employers will cap the percentage of your salary they will match. For example, my current employer matches 50% of my 401(k) contribution up to a maximum of 6%. That is, if I contribute 6% of my salary in 2006, they will put in an additional 3%. If your employer offers account matching, this is a definite reason to contribute, because not contributing is like saying “no” to a 3% raise!

Tax Deferral –– The other enormous benefit to retirement accounts is that you don’t pay a dime of tax until you retire (unless you cash them out early)! Basically, you get to keep a bit more money if you make tax free contributions to a retirement account than if you took the money as cash.

Automatic Withholding –– Let’s face it, I wouldn’t be in this mess if I had shown the discipline to save on my own. Even as I train myself to do this going forward, I like the fact that the money is deposited into the account before I even see it. If I had to put it towards a loan myself, who knows what else might come up that I would impulsively use it for.

Withdrawal Penalties –– Like the withholding, this is a good safeguard over impulsive withdrawals. Many employers will not let you even withdraw from a 401(k) while you are still employed, and if you choose to do so after terminating your employment rather than rolling the account over, you are taxed on the account as income AND face a 10% penalty. There are a million other reasons not to touch your retirement money early, but those are pretty good ones as well.

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Published or updated on May 5, 2006

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

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