I've been contributing 15% of my gross salary to my 401(k) for most of the time since I was 21. (I'm 32 now.) In the past I've been fairly naughty about spending too much and running up debt, so the forced savings was incredibly beneficial to me, but I seem to be more mature about spending over the past 4 years and want to be debt free and FI.

At this point I see the light at the end of the tunnel: While continuing to put away 15% to my 401(k) and after having reduced my expenses I am 29 months away from paying off all my debt.

After seeing it so close I want it to be even closer. If I drop my 401(k) contributions to 2% (just enough to get full company matching) I can pay off my credit card debt in 19 months.

(I am paying a relative $200 per month interest-free for a car. I would probably start paying more once my CC debt is paid off , but for purposes of this question and calculations I don't think the car payment or car debt enters into the equation.)

Furthermore, if I take a "5 year" loan from my 401(k) equalling 50% of my 401(k) or 11% of my total retirement nest egg (401(k) plus traditional IRA) I can pay off the credit card debt in 14 months, although it would take another 4 months to rapidly save up and then pay back the 401(k) loan early. (I can't "pay extra" on the 401(k) loan...only one lump sump extra payment allowed.)

The credit card is at 9.9%. A 401(k) loan would be 4.25% with interest going back into my 401(k). My marginal federal tax rate is 27% (hey, what happened to 24%?) and will be 27% throughout the possible range of my 401(k) contributions.

So my current choices seem to be:

  1. Continue to put 15% in 401(k) and pay off CC debt in 29 months.
  2. Put 2% in 401(k) and pay off CC debt in 19 months.
  3. Put 2% in 401(k), borrow 50% of 401(k)/11% of total savings and pay off CC debt in 14 months, then pay back 401(k) 4 months later.
  4. Put more in 401(k) until max reached or break even point with tax savings vs. interest on CC and pay off CC even later than 29 months. (I haven't really thought about this one much.)
  5. Check into rolling enough of IRA back into 401(k) and then borrow to pay off CC entirely then save up and pay back 401(k) ASAP. (I don't know if this is possible.)

The basic issues are:

  • Reducing/increasing 27+% tax liability with 401(k) contributions
  • Reducing/increasing 9.9% APR interest liability with paying down credit card.
  • Eliminating debt earlier to be FI and guard against unforseen job loss or other catastrophe.
  • Oppotunity loss of reducing 401(k) contributions that can't be "made up" later, and I'm probably 20-30 years from retirement so that's a lot of compound interest.
  • Opportunity loss of borrowing money out of the market for a time. (Depending on the market, this could be a good thing, but who has a crystal ball?)

I have just adjusted my 401(k) contributions to go with option 2 or 3 above. The interest savings does not offset the tax hit, but I dearly want to be out of debt. I feel secure in my job and my company, but right now I feel like it's worth the dough to eliminate the CC debt entirely. I think I will feel so free then and be able to max out my 401(k) and build up a cash cusion and start investing in taxable accounts.

I am thinking about taking a 401(k) loan and doing option 3. I think I would be motivated enough to cut spending to the bone and pay off the CC by the end of the year if I did this, but even if I didn't I'd still have it paid off by March 2004. However I perceive that the market is down and during the 18 months 11% of my nest egg might miss a surge. Then again it may avoid a drop.

Assuming my income is secure and no unexpected expenses arose I suppose it would make more fanancial sense to minimize my tax burden until the point at which the CC interest meets the tax hit. But then again what if my company pulls an Enron or Worldcomm, or what if my car breaks down and I have to spend a few thousand because of it? Or what if I get hurt and go on worker's comp or long term disability? Nearly half this debt was run-up while I was looking for work and trying to keep up with other debt; much of that was my fault and part was the job market.

Honestly the driving force is to feel free of the debt. That's what I'm tremendously focused on and excited about. I'm salivating at the thought of maxing out my 401(k) and IRA contributions, saving up 6 months or more of expenses in a money market IRA at Vanguard and then saving for a house and long investing in a taxable account. I'm sure I'd spend some more, too...Maybe I'll finally buy a Mac. But I will definitely be saving and making enough money to do all of the above. And I will finally be able to start really thinking about RE instead of how to get out of debt.

Am I stupid to "throw away" money (the 27+% tax) to pay off the CC earlier, or am I smart to get out of debt and be FI sooner even though it costs more now?

I thought about option 2 for a few days before deciding to change my 401(k) contributions. Option 3 only occurred to me a couple of days ago, but I'm very enthusiastic about the possibility of being CC debt free by 1-1-2004 or shortly thereafter. But I will wait and think at least a week before doing something as major as taking a loan against the 401(k), plus I like to be less emotional about my financial decisions and I'm very enthusiastic right now.

Something is telling me option 3 is a tad silly; I can rationalize it (I'll spare you the typing) but it is a bit silly to do that for ultimately a month or two of difference in when my real cashflow improves.

Okay, a little more typing: The rationalization for option 3 is paying off sooner and owing the money to myself; if necessary (job loss, catastrophe) I could just not pay it back and take the tax and penalty hit. The counterargument is that I could withdraw from my IRA or 401(k) and take the tax and penalty hit when and if I incur job loss or other catastrophe. That is as long as the market doesn't go down another 90%, and then I'd have bigger worries than the CC debt.

This post is a December 18, 2011 republication of my February 9, 2003 post on Early Retirement Forum.