The tussle between your 401K contributions vs other lucrative alternatives is as old as retirement accounts themselves (in fact please check out saving vs paying off debt). Most financial planners would choose the conservative option and advise you not to cut-down or delay your 401K contributions, but this way you might miss out on various investment opportunities or end up paying interest on debt that could have been settled for cheap.
In this article, we deal with all the possible questions you might have regarding this, and the right approach to take to secure and maximize your financial wellbeing.
Delaying 401K Contributions – What You Should Know?
If you’re financially strong and have sufficient monthly income to maximize your 401K contributions while still being able to clear off debt, you should definitely choose to do both, there is no doubt about it.
Now what we are left with is the sizable chunk of people who want to manage both, but don’t have the income to do so. They can make this possible by prioritizing between paying loans and investing in the 401k plan.
For example, if you have mounting credit card bills, it makes complete sense to set aside a bulk of your disposable income towards paying them off, and you definitely choose this over your retirement account, since the interest you pay on credit card debt is often many times higher than the returns you get from the 401K.
The biggest drawback with this approach is for those whose employer matches their contributions for the 401K, in which case the potential loss can be quite high, and might offset the short term gains in paying off debt. In this case, the right strategy would be to contribute an amount that matches and maximizes your employer’s share, but not beyond that.
Ultimately, the best way out of this dilemma is to find a way to balance the amount you spend and invest every month. It is not advised to neglect either one of these for the lure of the other.
How To Temporarily Reduce 401K Contributions?
If you are thinking of reducing your percentage contribution to the 401k plan, it is extremely important to consider your employer match. If your employer offers a full match, contribute enough to make sure you are not leaving that easy money at the table.
Initially, if you used to contribute 6% of your paycheck to exhaust your employer match, you should look at temporarily reducing the budget to 4% of your pay so that you get a 2% employer match. If you want to go further down, try investing 2% of your pay and get a 1% employer match.
Ultimately, your decision must be based on a cost/benefit analysis and the overall rate of returns among the various choices. It depends on your total debt obligations, your monthly income, other expenditures, and returns you can expect from other alternatives.
401K Late Contribution Penalty
The tax penalty for not depositing a 401k contribution on time is about 15% of the “amount involved”. The “amount involved” is simply the amount of money that missed being deposited into the funds.
So this is another factor that must be part of your decision making analysis. Would the 15% penalty be less than the long term cost of outstanding debt or returns of potential investment opportunities?
Max Out 401K Or Save For Down Payment
Deciding on whether to invest in a 401k contribution or invest in a down payment fund, all boils down to how much your income is, how much time you have in hand and how big or small are your liquidity needs.
The general advice for anyone making more than $50,000 per year is to max out their 401k plan regardless of an employer match. The idea here is to max out and then invest that amount plus 20% more after income tax into a safe down payment fund.
For those who earn less than $50,000 per year, it is strongly advised to at least contribute an amount that matches their employer contribution. For example, if your income is $40,000 per year and your employer contributes 3% of your base income, then you should look at contributing at least $1,200 every year towards your 401k plan.
Reducing 401K To Save For House
A house is probably the most important asset anyone can own in their lifetime. But if you look at it from a financial standpoint, your home is not a great investment. They don’t generate any income and require a lot of maintenance. However, it is a reasonable need to have a home on your name. That being said, consider a few things before you delay or reduce your 401K to buy a house.
Consider the security of your job against layoffs and external shocks from the economy. Ask yourself if buying is really needed when you have an option of renting. In the end when you have thought about all these factors, you need to weigh the benefits of having a home now versus having a secure retirement in the future.
Reducing 401K Contribution To Pay Debt
If you are standing at the crossroads of debt and retirement, you need to consider the type of debt, outstanding amount and the rate of interest to make a financially sound decision.
- Debt Type – If you are carrying huge student loans, it makes sense to pay them off first, especially if the interest rate of your loan is going to exceed the amount you’ll get from your investment. However, if you have a low-interest debt, you do not need to take away any amount from your 401k contribution.
- Interest Rate – If you have a high-interest credit card, it would be a wise step to lower 401k contributions temporarily and pay off the credit card bill. Also, paying off debt will increase your credit score and provide you with more financial flexibility.
- Debt Amount – Coming to the debt amount, it is a no-brainer to not touch 401k contributions if your debt amount is relatively lower. Instead, use the amount from your monthly income to fend off the debt over time while still saving up for your retirement.