Home & Family Finance Resource Center

Tuesday, November 24, 2009

Part 1: Expert Answers for Your 401(k) Questions—Save First or Pay Off Debt?

Darla Dernovsek

Building a 401(k) account that can support your future retirement needs requires smart decisions now. In the first of our three-part 401(k) scenario series, Tom Eckert, vice president of retirement services at CUNA Mutual Group, Madison, Wis., discusses the balance between paying down debt, beefing up your savings cushion, and continuing 401(k) contributions.

Q: I have $9,700 in credit card debt. I've tried, but I just can't seem to pay it off. I only have a small amount in emergency savings. The good news is that my retirement should be OK—when the stock market rebounds—because I put the max allowed into my 401(k). My brother says I should back off on my 401(k) contributions and redirect that money to pay off credit card debt and create a liquid savings fund that I can tap for emergencies. Is he right?

A: Your brother is offering good advice. It's best to look for ways to balance all three goals: contributing to your 401(k), paying down debt, and creating an emergency fund.

First, contributing to your employer's 401(k) plan is a very sound long-term strategy. Taking full advantage of your employer's match, if available, should be your priority, so plan to continue making 401(k) contributions to the level matched by your employer.

Second, before committing additional nonmatched dollars to the 401(k), it makes sense to pay down credit card debts, especially if they carry high interest rates. You might be pleasantly surprised by how quickly you can pay down your debt simply by temporarily shifting a portion of the 401(k) contribution to credit card payments. Figuring out how long it will take to repay the credit card can be helpful so you can remind yourself to resume increased 401(k) contributions as soon as the debt is repaid. That will keep you from spending money that should be directed to retirement savings.

Remember, you may be able to reduce the credit card interest you're paying—and the time it takes to repay your credit card debt—by asking a credit union loan officer if you are eligible for a low-rate balance transfer.

Third, you need to create a spending plan that includes setting aside money in an emergency fund to keep your finances in good shape. Record your expenses for a month or two. Analyze where your money is going and then decide what amounts should be set aside for monthly expenses and where you can pull back on spending. If you don't already use direct deposit to send your net pay to the credit union, consider adding that service so you can automate your good intentions. Or find out if your employer can deduct a portion of your paycheck and send it directly to a credit union savings account.

Those steps will make it easier to set aside money every month in an emergency fund, with the goal of saving enough to cover three to six months of expenses. This gives you a "security blanket" when unexpected expenses arise, or if you experience reduced hours or a job loss.

Once you meet your credit card and emergency fund goals, you will be in better position to max out 401(k) contributions again.

Readers should seek independent professional advice before making investment decisions.

Published August 24, 2009