Pay Off Debt or Contribute to a 401(k)?

With inflation not going down and interest rates rising, many Americans are wondering: Should I pay off debt or continue to contribute to my 401(k)?

It’s not surprising American households are feeling pinched. NerdWallet reports, “In the past year, median household income has grown just 4%, while the overall cost of living has jumped 8%”¹

As a result, more Americans are taking on debt just to afford the cost of living. 

We’re not talking about taking on debt for family vacations; we’re talking about the huge rise in the cost of essentials. It’s putting pressure on American households.

If you are one of the many Americans wondering whether you should pay off debt or continue to contribute to your 401(k), keep reading for tips on how to do both.

The State of Debt in America in 2023

pay off debt or contribute to a 401(k)

Following the pandemic, debt decreased. But with inflation and credit card interest rates now reaching 20%, many Americans are drowning in debt. 

Check out these recent statistics about debt in America.

  • According to NerdWallet, “The average amount of credit card interest paid by households is up due to recent Federal Reserve rate hikes and rising amounts of revolving credit card debt. U.S. households that carry credit card debt will pay an average of $1,380 in interest this year.”²
  • The average U.S. household owed about $222,000 in mortgages, $17,000 in credit card debt, and $29,000 in auto loans last year.³
  • According to Bankrate, “The share of credit card users who carry a balance has increased to 46% from 39% a year ago.”⁴
  • The latest quarterly report by TransUnion shows total credit card debt reached a record high of $930.6 billion at the end of 2022, an 18.5% spike from a year earlier. The average balance rose to $5,805 during this same time.⁵

Debt holds you prisoner while you are in it presently, but it also has an effect on your future. 

If you aren’t careful, debt can follow you into retirement and affect the type of retirement you have. 

The State of Retirement in America in 2023

pay off debt or contribute to a 401(k)

As the cost of living increases, so will the amount needed during your retirement years.

The problem is that inflation and interest rate hikes are making it more difficult for people to save for the retirement they want. 

A Northwestern Mutual Study found that “U.S. adults aged 18+ anticipate they will need $1.25 million to retire comfortably, a 20% rise since 2021. At the same time, Americans’ average retirement savings has dropped 11% – from $98,800 last year to $86,869 now – while their expected retirement age has risen – now 64, which is up from 62.6 last year.”⁶

The same study found, “More than four in ten (43%) people say they do not expect to be financially ready for retirement when the time comes. […] Meanwhile, one-third (33%) of Americans expect to live to 100, with an equal third (33%) predicting there is a better than 50% chance they may outlive their savings. At the same time, more than one in three (36%) report that they have not proactively taken any steps to address this concern.”⁷

And, according to Fox Business, “Forty-one percent of survey respondents said that inflation was the most significant obstacle to reaching financial security in retirement, while 39% blamed the economy.”⁸ 

Add in debt – especially high-interest debt –  and it is even harder to save for a comfortable retirement.

[Related Read: 13 Ways to Avoid Cutting Back on 401(k) Contributions amid Inflation]

Debt and Retirement

pay off debt or contribute to a 401(k)

If you are drowning in debt, consider whether your retirement income will even be enough to cover your monthly debts.

This might make you feel as if you need to focus solely on paying off debt and not contributing to your 401(k).

But that also has consequences.

For one, if you focus only on paying off debt for 5 years, you may be debt-free in 5 years, but you will also be 5 years behind on retirement savings.

You will have potentially missed out on 5 years of compounded investment returns had you consistently contributed.  

Plus, those with a 401(k) who didn’t contribute at least the company match while paying off debt over these 5 years may have missed out on 5 years of free money. 

This is even more significant beginning in 2023 as 401(k) contribution limits have risen to $22,500 from $20,500. 

On the flipside, interest rates on your debt may be higher than the return you could expect on your retirement investments.

Let’s say you have $10,000 in credit card debt and you pay 13.98% APR. Let’s also say you have a 401(k) with an expected annual rate of return of 7%.

If you decide to only pay the minimum on your credit card and divert what you can into your 401(k), you would be losing money over time on the amount you invested – 6.98% to be exact.

Rethinking the Question: Should I Pay Off Debt or Contribute to My 401(k)?

pay off debt or contribute to a 401(k)

The best way to answer this question is to change the question. Instead of debt payoff OR saving for retirement, use AND. 

How can I pay off debt AND save for retirement?

Here are some suggestions on how to do both: 

  • Pay off high-interest debt first, while saving something for retirement. It is critical that you at least contribute enough to your 401(k) to get your company match because that’s FREE money. Aim to contribute enough to get the company match and then divert any additional retirement savings to pay off high-interest debt.
  • Create a budget that prioritizes debt repayment while still allowing you to contribute enough to your 401(k) to receive the full company match.
  • Once you’ve paid off your high-interest debt, continue paying a bit over the minimum on any lower-rate credit cards or debt you have.
  • Then, divert more money to fund an emergency savings account. If you want to avoid getting back into debt, you need access to cash.
  • Once you have built up your emergency savings, increase your retirement savings (even a small percentage makes a big difference) and continue paying down the debt you have.
  • Once your debt is manageable or gone, try to max out your yearly 401(k) contributions.
  • Continue funding your retirement even as you approach it.

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