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Advice For a Reader – What Would You Do In This Situation?

By JLP | March 26, 2008

Last month I wrote How Much Will That 401(k) Loan Cost You?. The other day a reader named Mark left the following comment on that post:

But, I have a different scenario…

Status:
Company match is 100% up to 4% of pay, none thereafter.
Contribution is at 10%
401k return so far this year is -8%
I am over 50.
Large amount on credit card (CC) to repair Mom’s house for sale – but there it sits waiting for a buyer in this market.

Rather than take a 401k loan to payoff the CC, I am considering reducing the 401k contribution to 4% so I still get the company match, and get a little extra payroll $$ to accelerate payoff of the CC.

Once the CC is retired, the percentage would go back up to at least 10% (if not more). Once the house sells, I can put the money back in to the 401k in $5k chunks under “catch-up” provisions.

Your thoughts?

My thoughts

Mark didn’t furnish us with his credit card’s interest rate so it’s tough to say which way makes the most sense financially. If the interest rate on the card is high, then it does make sense to pay if off as quickly as possible even if that means reducing (but NOT eliminating) his 401(k) contributions.

We also have to assume that cash flow is the main issue no matter how the debt is financed—whether it’s on a credit card or some other loan. So we’ll assume that reducing his 401(k) contributions is his only option.

So, based on the information Mark furnished us with, I think his strategy makes sense. I like the fact that he is only reducing his contributions to the point where he still receives the full company match. This is very important since it is free money. It’s not likely to be a good idea to pass up a company match.

What are your thoughts?

Topics: 401(k), Credit Cards, Investing, Retirement Planning | 11 Comments »


11 Responses to “Advice For a Reader – What Would You Do In This Situation?”

  1. Heidi Says:
    March 26th, 2008 at 12:15 pm

    I agree with you (and Mark). Contribute the 4%, and then pay off credit card debt.

    If he finds that he has a little left over at the end of every month, he should put it savings and once he’s accumulated enough to open a Roth IRA, he should do so.

  2. Zulu Says:
    March 26th, 2008 at 1:05 pm

    The balance and rate of the CC would be nice to know, but unless incredibly awful wouldn’t change my approach.

    His new plan sounds pretty good to me. Further, I can’t really see a compelling argument for the 401k loan approach. I’d use that as a last resort. The very fact that he can consider just reducing his 401k contributions tells me he is not likely in dire straits.

  3. Roman Says:
    March 26th, 2008 at 1:08 pm

    It makes sense to a point. But will 2% be enough to over the cc? Will he also be missing a opportunity to invest in a lower price and watching his 401k rise? Will the house be sold? There are too many unknown factors that can make or break everything.

  4. AJC @ 7million7years Says:
    March 26th, 2008 at 1:19 pm

    If he has 10+ years left until retirement (65? I just retired at 49) then I am not a fan of investing inside a 401k – other than for company match.

    By all means pay off c/card, although I would be much more tempted to buy the house from Mom … will she carry-back financing? If not, roll in the c/card and refinance the whole shebang and lock in until your expected death-date.

    Rent out, cover any shortfall with the other 6% of your contributions and whatever else you can scrape up and you just may end up with a nice source of retirement income, in addition to your 401k.

  5. No Debt Plan Says:
    March 26th, 2008 at 1:55 pm

    Agree that there aren’t enough details, but sounds like a decent plan. I do wonder how fast an extra 6% of that income (minus taxes) is going to increase the credit card repayment. I would look into other methods as well — earning extra income, or cutting expenses.

  6. Independent George Says:
    March 26th, 2008 at 2:20 pm

    Depending on the size of the CC balance and his credit history, I’d start with the 0% balance transfer game before reducing the 401k contribution, then pay off the remaining balance, then put the extra income into a dedicated savings account to cover the debt.

  7. Jeremy Says:
    March 26th, 2008 at 6:53 pm

    This reader is at least on the right track, and I meet with people almost every week with very similar questions. Reducing it by 6% while still getting a full match on the first 4% is a great start. Since he isn’t even considering going below the match, I see nothing wrong with that aspect of it.

    The real question is, like you pointed out, is how much the debt is, and at what interest rate. This could affect how beneficial this strategy is. Also, how much would that extra 6% be to apply towards the debt? Enough to pay it off in 5 years? 3 years? 1 year?

    But the way I see it, since he’s still contributing 4% and it is getting matched, he’s getting a 100% return on that money while it is still being invested, keeping his DCA alive and buying in at these low prices. Then if the credit cards are anything over about 15% and the 401k contribution reduction could knock this out in about 2 years or less, this is pretty much a solid solution.

    But again, without every detail, it is hard to say for certain, but his plan is a lot better than what I see a lot of people come in with.

  8. TXAG03 Says:
    March 27th, 2008 at 8:09 am

    While we don’t have enough information to fully answer the gentleman’s questions, I think it is important to look at how to analyze this situation.
    First, the fact that the investments in the 401(k) (important: a 401(k) itself does not have a return, only the investments inside of it) returned -8% does not factor into our decision. It’s in the past, and there are no guarantee’s which way the market is headed. Second, JLP would be better at determining the tax implications of you using the proceeds from your MOTHER’S house for your catch up contributions. Here are the assumptions i draw from that statement. 1) 10% maxes out your $15k 401k allowance, otherwise we wouldn’t be talking about catch-up contributions so you make around $150k+ 2) Mom is elderly and money is tight, since you are selling her house and she is not paying for repairs, be careful you’re not violating some Medicare provisions or messing up estate tax and basis step up provisions.
    Why do you have to pay the credit card off right now??? Make at least the minimums, look for balance transfer offers, or even a HELOC and knock it out after the house sells. Otherwise you are giving up the tax benefits now, tax deferral, and potential growth by reducing your contributions. Here’s the formula you should use:
    Principle on loan * interest rate = interest payment (you loose this per year keeping the card)
    Salary * (10%-4%) * marginal tax rate = tax refund given up
    tax refund given up + interest on loan while you pay it down = you loose paying off the card.
    Whichever is lower will give you your answer on what to do. I assume you were going to make the catchup contributions without the house sell anyway, so it gets tossed out.

  9. Moneymonk Says:
    March 27th, 2008 at 12:14 pm

    Just pay off the credit cards regardless of the interest.
    All this borrowing from Peter to pay Paul is crazy

  10. Mark Says:
    March 28th, 2008 at 5:51 am

    Ya’ll are incredible!
    The cc is 8% and the amount is right at $12k. The balance transfer option is a great idea…but I only keep two cards and the other is paid off monthly. My goal was to keep the house repairs separated so that there wouldn’t be any confusion later on as to who paid for what. Mom only has her SS for income and the current plan is for her to live in her own house until old age or medical factors intervene. I make sure she stays well above water, just it is not from the deck of the Big Red Boat! :)

    After reading through the advice – I definitely need to find out about the Medicare and estate impact. I will also consider purchasing the house – but have some concerns about taking on the additional debt load. Sometimes renters do bad things….like not pay the rent.

    My healthy dose of paranoia starts with: If everything went to hell in a handbasket…

  11. EMF Says:
    March 28th, 2008 at 11:19 am

    I would be sure to document whatever you’ve spent on your mother’s house as a loan. Receipts for sure, a loan document with your mother would be better. Maybe you’ll not be paid until you inherit, but having that documentation could reduce your tax bill.

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