Have you thought about stopping retirement contributions because some finance guru told you to pay off your debt first?
Or maybe you aren’t sure if you should start contributing when you have debt to pay.
A lot of people will even tell you to go ahead and pay off the high interest rate first because it accrues more than the market….
Well today I’m going to discuss the actual numbers and how all that logic is flawed except for in a very very small fraction of the population.
I’m Ashley with Budgets Made Easy and you’re listing to the Money Mindset Podcast where we help support you with your debt pay off journey without all the shame and guilt so you can let go of the fear of failing and start living the life you deserve!
Before we get started, don’t forget that for the month of March 2023, we are accepting entries for the week of giveaways! All you have to do is leave a review for the money mindset podcast, take a screenshot and submit it at www.budgetsmadeeasy.com/giveaway
The calculator I used - https://www.calculator.net/debt-payoff-calculator.html
Now let’s discuss holding off retirement savings when you have debt.
When we were paying off debt, I was not comfortable with doing this at first, even though I was listening to Dave Ramsey at the time and he said it over and over.
I now longer follow Dave and generally can’t stand the man anymore, which I discuss more in detail as to why in episode 62 - Why I quit Dave Ramsey.
At the time that I was considering stopping contributions to retirement, We had already paid off 2 of our 3 debts.
The last debt was my student loan debt and our largest debt and it was accruing over $5 a day in interest! So I wanted it paid down fast.
It had been 10 years since I graduated college and I had only paid off around $3000 in that time.
So I was motivated to get it done quickly.
We had consistently put in around 3% each plus 6% into my pension + 5% from the town I worked for for over 10 years. We were in our early 30s still so we had a lot saved and we will retire as millionaires even if we didn’t contribute another penny.
When trying to decide if it was worth it or not, I did the math to see if it would be worth paying off the debt with our retirement contributions.
I did not have a choice on contributing the 6% to the state pension and the town put in 5% for me that did not cost me anything. So even with stopping extra contributions, I had 11% going into my retirement.
Now I can’t remember the exact numbers since it was in 2016 and I had no idea that I would be starting this career within a year and talking about our journey so much but I think we were putting around $4-500 a month toward our 401(k)s at this time.
I knew that after taxes, I could bring home around $300-$400 per month to apply toward our largest and highest APR debt.
But the APR was only 6.75% or right around that.
At this time, I did not know about the rule of 72. Which I will explain in great detail in just a minute.
It seemed like a good option to help us do it faster so that we could get back to saving for retirement. I did not really consider all the factors going into this decision because I just didn’t know and a guy who seemed more knowledgeable about it than me said to do it.
The problem with this thinking though is that once you start bringing home the extra, it’s hard to start sending it again and not have that coming home in your paycheck.
You get comfortable with the paycheck amounts and it’s hard to hit the button again to not have that money each month.
We ended up not turning back on contributions for longer than I wanted because I wanted to save but then things kept coming up that kept us from saving as quickly as I wanted.
So we ended up skipping contributions for a year or so.
Now, at the time, I thought it was a good idea even though I did not for the first half of our journey.
I also did not realize the true cost associated with that year until I was doing the prep for this episode.
I’ve done the math for our 401(k) loan and know how that impacted our finances in the long-term but I’ve never actually calculated the year of not contributing.
I go into detail on that long-term cost of the 401k loan in episode 120 - Our Worst Financial Mistake That Cost Us $1million dollars 😲
Now the year of not contributing is not as drastic of an impact as that 401k loan but nonetheless, the cost is a lot higher than my original calculations.
I honestly don’t think that people that give this advice have ever thought through the long-term cost. Yes in the short-term, it seems like a logical math based decision but it’s really not.
I did not even know the true cost until I started working on this episode!
Now if you are following the advice of - you have to pay off your debt and save 3-6 months of expenses BEFORE you start contributing toward retirement.
For most of you that will be at least 2-3 years. But for a lot of you, it could be 5 years, which is too long to be out of the market. Generally speaking this advice is for 2-3 years, not 5+ years. So if you already stopped your contributions, do not stop them for that long and I’m going to explain why…..
First let me explain why you should keep contributing if you already are and not shut them off to pay off debt faster.
The true cost can be calculated using the Rule of 72
the Rule of 72 is used to estimate how long it will take to double an investment at a given interest rate. Divide 72 by the interest rate to see how long it will take to double your money on an investment.
Now there is a whole formula to do this calculation….but you don’t need to know it. Just Google the rule of 72 calculator and there are several that will do the math for you.
For our math today we will use 10% avg return which doubles every 7 years - 10% is the average rate of the stock market. Of course, some years are high, some low, but the average is what matters - plus it’s the reason you shouldn’t try to time the market but that’s a discussion for another day.
For our first example, let’s say you are
35 years old - 30 years from retirement
$100 per paycheck - 26 a year = 2600
Per year =
5 doubles if retire at 65
5200
10,400
20,800
41,600
$83,200 - losing at retirement each year per $100 a payday
For us that’s $83,200 * 3 = $249,600 for the one year - guess what? My accruing interest was not even close to that amount. I really only saved around $2000 in interest by paying off my student loan a year faster.
Now for that math, I was 31, not 35 so that’s half of a doubling….which means we really lost around $375,000!!!! Because of our age at the time
I’m kind of wishing I didn’t just do that math….
This whole journey of taking money out of retirement has cost us almost a million and a half dollars when we retire….
Now for that 35yr old example if they stop contributing for…..
2 years to pay off debt - costs $166,400
3 years to pay off debt - costs $332,800
For just $100 a paycheck!!!
So if you are thinking, you “don’t have the money” to contribute toward retirement….you are wrong. $100 a check is really only around $70ish dollars in take home pay. That’s the cost of one meal at a restaurant - even less if it’s my family LOL
But I also know that most of you are older than me, so for easy math, let’s say you are…..
42 years old - 23 years from retirement
$100 per paycheck $2600 per year
$41,600 per year
2 years to pay off $83,299
3 years to $166,400
Now I’ve also done the math for an example of what you are saving in interest because the comparison is important…..
If we take that $100 per month and apply to our debt instead….because keep in mind that 401k contributions are pre-tax.
So if you stop the $200 a month contribution, you’ll bring home around $150ish
Let’s be real, you probably won’t send that whole amount to your debt.
So if you take $100 per month of that $200 and put it toward your debt, you will save $2000 in interest. For the $100 per paycheck example.
Now, remember the cost of that year was $83,200 for a year in lost money at retirement.
In case you need me to do that math for you, you’re losing $80,000 by stopping contributions for a year.
Now in using the same debt payoff calculations, that extra $100 per month still only has you debt free in over 3 years. So, that’s 3 years of not contributing which is a cost of over $322,000 at 35yrs old or $166,400 at 45 years old.
That means, mathematically, it does not make any kind of sense to stop contributions to pay off debt faster - EVEN WITH HIGH INTEREST RATES.
Now there are times where you may want to consider stopping contributions to focus on debt when you’ve already been contributing.
If you are not actively working a debt pay off plan and have not worked on changing your behavior then do NOT stop contributing.
The long-term costs will be enormous and the chances of you following through with paying off the debt and starting contributing again is very low.
Leave it alone if you are still working on impulse spending, sticking to your budget, and feel overwhelmed and aren’t making any progress on your debt pay off goals.
If you are already contributing AND have room in your budget to live and pay off debt, then you don’t need to stop.
Now If you aren’t already contributing and DON’T have any extra money to contribute, then focus on debt first.
If you are within 5 years to retirement, pay off debt first if you have to make a choice.
The goal is not retire with a bunch of debt. Because if you don’t have any savings, you won’t be able to pay your bills with social security. It will be more manageable without a bunch of debt.
Plus you won’t have much time to save and you’ll want more conservative investments so your ROI will be lower as well.
It makes sense to pay off debt first in this situation.
If you are 10 years out or more from retirement, contribute to retirement and if you have some extra, pay off debt as well.
To recap - do not stop contributions - it’s not worth the long-term costs unless you are within 5 years of retirement.
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Go submit your review at www.budgetsmadeeasy.com/giveaway
Have a great week!