Reader Question: Pay Off Credit Cards vs. Invest Your Money?

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I’ve gotten a few variations of this question recently:

I’ve only got about $5,000 in savings and about $4,000 in credit card debt. I’m not sure if I should pay off my cards first before I decide to invest or what. I’m just looking for a way to make my money work harder. – Michael, New Investor

I indirectly addressed this topic in my post titled You Have Some Money. Where Do You Put It?, where the my top 4 were listed as:

  1. Invest in your 401(k), if you have one, up until the match.
  2. Pay down your high-interest credit card debt.
  3. Create an emergency fund with at least 2 months.
  4. Fully fund your Roth IRA.

If you read through the many thoughtful follow-up comments, you’ll see that many people have differing views on this. I’ll try to clarify my own positions here, but although I will try to provide good reasons behind then, I do agree that this is all very subjective. As usual, the ultimate goal is to present all the arguments in order to help everyone better determine their own personal solution.

#1 Invest in your 401(k), if you have one, up until the match.
Many employers offer matching 401(k) contributions. So if you contribute $100 from your paycheck, your employer will also chip in $50-$100. This is an instant 50-100% return… Some would even call this free money! Unless your credit card interest rates are over 50%, mathematically you are ahead by far. In addition, you have now started your nest egg for retirement.

Exception: The benefit of this match gets a little hazy as often you have to work for a number of years before the matched amount “vests”, or officially becomes yours. You may never actually get to keep much of the match if you only work for a year or two, so take your long-term prospects into account.

#2 Pay down your high-interest credit card debt.
Here we reach one critical debate: Paying Down Debt vs. Roth IRA. On one side, we have high interest (say, over 8% right now) debt. On the other, we have the opportunity for tax-free growth.

My argument here is, again, simple math. If on one hand you have money in stocks growing (maybe) at 10% tax-free, and on the other hand you have money shrinking at 18% with no tax deductions, you’re still losing money! Therefore, I feel the best general decision is put all that money towards your debt. Yes, saving now may mean much larger balances later, but remember, here you are choosing one or the other here, and not paying off the credit cards puts you behind.

The counterargument to this is that you only get to put in $4,000 in a Roth every year and that is precious. You can’t put nothing in this year and $8,000 next year. If you are sure that your tax rate to be higher in retirement than now, and you don’t expect to have access to other similar options like a Roth 401(k) or 403(b) in the future, then I can see how putting money towards the Roth may be better.

(Now that I think of it, another reason might be that Roth IRAs are protected in case you decide to wipe out all your credit card debt in bankruptcy court…)

Exception: One should always try to lower their interest rates if possible by calling the credit card issuers directly or, if your credit is high enough, try to get a low interest balance transfer onto another card.

#3 Create an emergency fund with at least 2 months.
Here is another hard question: Where does an emergency fund play into all of this? Overall, I think people should pay down their high-interest debts as much as possible before saving up 6-12 months of emergency funds.

Why? For one thing, if an emergency does occur, many expenses can be simply be put back onto those same credit cards: utilities, food, clothing, medical bills, etc. Other things like rent can be paid via cash advance. Since it’s most likely an emergency won’t occur, you’ll be saving a lot of interest by paying off the high-interest debt now.

The reason I put 2 months down is because I wanted to designate this a “barebones” emergency fund. The actual amount needed depends heavily on the individual: How stable is your job? Do you have disability insurance? Would your parents or someone else bail you out?

Fully fund your Roth IRA.
Although you can withdraw your contributions out of a Roth if you need to, the Roth should be a last resort. Therefore, you have the “barebones” emergency fund first, and then the Roth IRA. Should a Roth be above even a barebones emergency fund? That’s a judgment call. In my mind, a barebones emergency fund is maybe $2,000. Otherwise, you’re literally living paycheck-to-paycheck, during which I would worry about now first before the future and Roth IRAs.

Exceptions: As noted earlier, the Roth IRA is really only better than a Traditional IRA or 401k if you expect your marginal tax rate to be higher in retirement than when you make your contributions. If you expect them to be the same, they are essentially equal, with the Roth taking perhaps a slight edge. Here’s the math showing why… Say you have $10,000 pre-tax income to contribute, 25% marginal income tax rate both now and in retirement, 8% annual return, and a 30 year horizon.

401k (pay tax later):
( 10,000 x 1.08^30 ) [compounding] x ( 1 – .25%[tax later] ) = $75,469

Roth (pay tax now):
( 10,000 x ( 1 – .25%[tax now] ) )x (1.08^30) [compounding] = $75,469

If your tax now > tax later, the 401k comes out ahead. If tax now < tax later, the Roth wins. Please share your thoughts in the comments, if I haven't confused you completely already...

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  1. move the credit card debt to a no interest card and fund the Roth. Then you can gradually pay down the credit card debt interest fee and you also have more time to pay off the card.

  2. I have had the same strategy as Paul suggests for two or three years now. I’ve been successful at keeping my debt expense $0 not paying any balance transfer fees or anything for the past three years or so. It seems it can do no harm to my credit score. I keep an American Express One Card, Discover, and a Citibank Visa in my wallet to use in that order of preference (AMEX deposits the 1% every month in a 5% APY savings account where it is immediately compounding and accessible, in my mind the easiest cash bonus card – Discover I have to remember to transfer out in $20 increments and it doesn’t earn anything whilst in their clutches – still haven’t figured out how to get my supposed 1% out of the Citibank) Meanwhile the debt goes wherever the balance transfer deal is for the present and I set up an automatic payment for minimum balance from my bank.

    My thinking originally was that any extra money could be left to compound in my high yield savings and then I could pay down the balance while doing the next round of transfers. Only problem is there really isn’t much incentive to pay the balances down each time I roll the balance and I still have $9k of credit card debt that really isn’t disappearing in any hurry. To get it off my shoulders, I’ll be adjusting my 401k contribution down to just above the level I’ll get the max match and adding the net on to my automatic monthly credit card payment – forcing me to get rid of this baggage.

  3. I’d just pay the cards unless you have the 401(k) match. Even if your cards were charging you a rate of only 10%, you’d save $400/yr of interest payments. Even in a low tax bracket, that $400 saved is probably the equivalent of $500 real income because of the taxes you’d pay on income (even more if it is W2 income you’d have to pay social security on).

    Reducing expenses goes way further than earning extra.

    If you have the 401(k) match? Personally, I’d probably still pay the card even though the math isn’t quite as good but I would also change my withholdings to immediately start taking advantage of the match each month. You might not max out the match this year, but you’ll be set going forward.

    I don’t see much point in waiting to change your withholdings. You’re going to want to take that match going into the future and you’ll have to figure out how to live on that reduced amount of income.

  4. Sorry, my calculation didn’t include the interest on the $4000 you have saved now (although if your cards are 15% and your savings is 5% I’m still covered). The point is that you pay tax on your interest income and you don’t save tax on your interest payments. So your interest earned counts a lot less that your credit card interest.

  5. This is a good article overall. I think transferring CC debt to another CC debt as Paul suggest works fine too, but nothing beats paying down debt because it will always be a burden. We speak theoretically, but the problem is whether or not you can keep away from incurring new debt.

    Another idea I have (which is slightly risky), is if your employer match, then contribute to 401k first. Assuming you have enough money, take out a 401k loan to pay of the credit card. Try not to incur new debt and restore your 401k as soon as possible.

    I would do this for small dollar amount, but would not risk my 401k for anything that’s too big because there’s always a chance I can lose my job and have to pay everything back or face the penalty.

  6. My current job doesn’t provide a 401k, and in fact, none of my jobs ever have, so I don’t know much about them. From what I’ve read on PF blogs, it seems like they offer a pretty limited choice of investments (usually a few mutual funds), but they give you a big match (like 50%) up front. Mutual funds usually lag whatever market segment they follow, due to fees, so consider this: Even with the 50% match, a 2% difference in returns will make up that difference in 21 years, or a 3% difference in 14 years. For instance, $1000 invested in your 401k at 9% will be $1000*1.5*1.09^30 = $19,901 in 30 years. But $1000 invested in a Roth at 12% will be $1000*1.12^30 = $29,959 in 30 years. This isn’t for everyone, obviously, but if you’re the kind of person who feels like they can do “better than average” in the market, it’s something to think about in terms of funding your Roth IRA vs. your 401k first.

    I agree high credit cards should be a top priority.

    I guess my list (since I have no 401k) would be:

    1. Fund Roth IRA at least minimally ($1000 or so?)
    2. Pay high interest cards (or transfer balances to low interest cards)
    3. Fund remainder of Roth IRA
    4. Pay medium interest cards
    5. Invest in taxable accounts, and keep some amount in bonds or bond funds (treat it as an emergency fund… and if you have to go through the hassle of selling your bonds and transferring money to your checking account, you really will only use it for real emergencies!)

    If I did have a 401k, I’d put it between #3 and #4.

  7. Ted Valentine says

    I have to go with Dave Ramsey on this question: Make a written budget, make minimum payments on everything until you have a $1,000 emergency fund, attack all debt smallest to largest, snowball payments until your debt is gone except the house, fully fund 401k and IRA.

    The guy has helped and counseled thousands upon thousands get out of debt and get on the track to wealth. It works every time. I know because I started following the plan over 10 years ago.

  8. If you and your wife each make 6 figures+ like us the 401k is the main option, a roth isn’t available as you aren’t eligible. You are eligible to pay the tax man big $$$ in CA as the topline state income tax is 10%!

  9. I believe Suze Orman’s philosophy is similar to yours and she has a step 5, which is put any additional money in your 401k.

  10. Confused says

    I still am not understanding why it is generally accepted that a Roth is better than a traditional IRA. If you assume that the marginal tax rates will generally stay the same (as this example does), and ignore the contribution limits (which I guess is an advantage, but has nothing to do with actual returns), I don’t see how a Roth is better. If you are putting pre-tax dollars in a traditional IRA, and assuming your in the 25% bracket, then these dollars are saving you 25% of the entire contribution over a Roth. When this money is withdrawn however, the entire withdrawn amount is not taxed at 25%. As the brackets stand right now, the first $7,800 withdrawn in a year is only taxed at 10%, then the next $24,000 is only taxed at 15%. This gives a total tax rate of about 13% on the first $30,000 withdrawn in a year. This means that in a Roth, you would have already paid 25% on this first $30,000, but in a traditional, you would only pay 13%. Isn’t this correct? Am I missing something? Or are distributions from a taxable retirement account taxed differently than normal income?

  11. I don’t usually agree with you, Ted Valentine, but I got your back on this one. Not to preach Dave-isms or anything, but his advice truly works. Michael, if you didn’t already have the money in savings to pay off your cc debt, I’d say to STOP the 401K contributions altogether, until the debt was paid off. But since you’ve got the cash, just get the damn debt out of your life! It’ll have an immediate positive effect on your financial well-being, and you can then move on to fund your chosen investments. However, I’d also advise gathering an emergency fund BEFORE you start investing.

  12. Steve Austin says

    I like Paul’s idea (transfer debt to 0% card, which would usually be limited to 12 or 18 months), if you can get such a card. I don’t use cards so I don’t know much about the terms and conditions of an agreement like that.

    Accelerate The Match, Then Pay Off The Debt:

    With a 12-month 0% debt account, it does make sense to max out the matchable 401(k) contributions, and you might even be able to accelerate the plan in order to allow you to start paying off the card debt (hopefully at 0% for a while) sooner. Most 401(k) plans allow you some latitude on what percentage of each paycheck is deferred into the 401(k) account. Some allow 100% (or close to it, less your FICA, benefits, misc deferrals), others cap it at 75% (so they never have to worry about underfunding FICA and the other stuff).

    So if you can swing it for a few paychecks in Q1 of each year, max out your salary deferral until you have fully availed yourself of your company’s matching contributions. Then lower your salary deferral to 0% for the rest of the year. Repeat the next year, but remember to set aside some cash in Q4, so that your cash flow is even in Q1 due to that heavy salary deferral.

    Detailed Example:

    Your annual salary is $50,000; your company 401(k) plan matches your contributions at 50c for every dollar up to 6% of your salary (in effect they give you an additional 3% of your salary, in your 401(k) account as long as you yourself contribute 6% of your salary to that account).

    So you plan on raising your salary deferral in January to 75% (of your ~$2000 paycheck) and after two semi-monthly pay periods, you’ll have contributed about $3000 to your 401(k) account, which is 6% of your salary, all you need to get your company’s matching contribution in the amount of $1500 (3% of your annual salary). Now adjust your salary deferral to 0% for February and beyond.

    Then you’re done with your 401(k) for the year and can focus on paying off that debt on the (hopefully 0%) card.

    In addition to an emergency fund, I like to gatherin Q4 all cash needed for my 401(k) and Roth IRA contributions that I make in Q1. Some people like to make their IRA contributions in April for the *previous* tax year; others like to spread them out quarterly or monthly (or semi-monthly) throughout the tax year. I like to make the $4k or $5k contribution in the first week of January each tax year (not for the previous one). As soon as I max out my 401(k) contributions (usually takes 4 or 5 semi-monthly paychecks), I am done with retirement account contributions *for the year*! (Done over the course of a working lifetime, this gives one an *extra year* or so of tax deferred — tax free in the case of the Roth IRA — investment growth.)

    I couldn’t just jump into this, it took me a couple of years before I was at steady-state on the approach. But it enforces savings discipline once you have it in place. To do this, you have to have your expenses on a well-known, predictable budget (w/ the emergency fund in place to absorb any unplanned financial events). Most of Q2 through Q4 savings are directed to non-retirement investment accounts and then in Q4 to set aside enough of a surplus in the savings savings account in order to fund the annual retirement plan contribs in Q1.

  13. SavingDiva says

    I would just prefer to be out of debt and pay off my credit cards as soon as possible. However, I recently wiped out my EF, but I’m going to continue to fund my 401k and Roth while I rebuild my EF.

  14. I second the budget comment. Look at why you have $4K in debt… do you need to change your monthly spending habits so it doesn’t just get re-created again? Or was it a one-time splurge? Are you able to save 10% of your take-home pay for retirement, and another 10% for “not this month” stuff like your emergency fund, furniture, vacations, etc? (this assumes you aren’t a student or living in San Francisco) This 20% could also go to debt reduction as Jonathan and others detailed.

    The Dave Ramsey method of smallest-to-largest debt (instead of largest-to-smallest interest rate) works on a psychological, rather than a mathematical level. People who are paralyzed by very large debts (and bad spending habits) will likely do better with Dave’s method.

  15. triple-e says

    One thing that your Roth vs. 401k comparison doesn’t show, is that while they both earn at 0% tax, when you withdraw from the Roth, you get to keep the 0% and not pay tax on the earnings, right? Or don’t I understand 401k very well?

  16. I think there are two sides to this equation.

    There’s math and then there are emotions. If I have 5k on my Credit Card, the fianc? gets antsy, she feels “on the hook” for that money, she doesn’t really like owing people money and frankly nor do I.

    So when the CC has a balance, I make minimal (10% of salary) RRSP deposits and then work on paying down the card. (RRSPs are very similar to 401k, tax defered growth, gets taken off the top when calculating income taxes).

    The reason I do this is not that it is the most mathematically efficient, but it’s emotionally efficient. Keeping up the “pay yourself” habit is very important and diving in to savings to pay off CC debt opens the door to do it again.

    So instead, I’m suffering a little, but that serves as a little training as well. Now obviously, YMMV, but I think that if the debt load can reasonably be paid in less than a year, then it’s probably worth continuing the savings plan. I don’t like breaking good habits to try and fix bad ones.

  17. For a well disciplined individual there’s alternatives to keeping a cash, MMF or CD ladders as an emergency fund. For example, an HELOC can serve as an emergency fund.

    I’ve done it myself when I was somewhat cash short. I carried no debt (other than mortgage) and was flush in my retirement accounts. I had two houses (one was a rental that I’d just finished renovating). The HELOC carried the remainder of the mortgage balance on the rental property plus renovation costs (at around 4% IIRC).

    Once renovation was complete I started paying down the HELOC and the mortgage on my primary residence as quickly as I could. I didn’t build a cash reserve because I knew I could pull from the HELOC in the unlikely event a disaster occurred. I kept the HELOC in place (with zero balance) for a couple years — it only cost $50/yr and instead of an emergency fund I made longer term investments.

    As things have changed in my life and as rates have climbed, I have switched to CD ladders for my emergency fund. But I just wanted to point out that in the right circumstance a HELOC can serve the same purpose, or be a bridge if your emergency fund is in intermediate investments.


  18. How should I go about trying to figure out what my tax rate would be in the future to decide between a Roth and regular IRA? Also, what are the requirements for having a Roth IRA? Rob seemed to be saying that if you make 6 figures they are unavailable.


  19. Ted Valentine says

    HELOC would be 8%+ these days.

  20. tryintobefrugal says

    In Roth IRA discussions, I think we’re forgetting about the fact that in traditional 401k / nondeductible IRA the money you’ve contributed AND the compound interest on them are taxed at withdrawal.

    In case of Roth IRA, only principal is taxed, so to me it’s a clear winner no matter what your tax bracket is when you retire, because, if you contributed regularly over a long period of time, you’ll probably end up with much larger compound growth on your money than your principal which you contributed.

  21. I think this is a great discussion, and it shows that there are so many variables you just can’t make a list and expect it to work for everyone. Let me add some quick comments:

    Jason – Glad you could find a lower rate, many people with debt have lesser scores and have a hard time getting it down to 0%. Since your debt at 0% may not stay that way forever, I agree that you should increase your payments before.

    Jon – Another factor to consider. However, many people have very good options in their 401k, I used to have all the Fidelity Spartan funds with no minimums. Also, if you cherry-pick the funds (see my last post), your lag might only be about 0.30-0.50%.

    tryingtobefrugal –

    “In Roth IRA discussions, I think we?re forgetting about the fact that in traditional 401k / nondeductible IRA the money you?ve contributed AND the compound interest on them are taxed at withdrawal.

    In case of Roth IRA, only principal is taxed, so to me it?s a clear winner no matter what your tax bracket is when you retire, because, if you contributed regularly over a long period of time, you?ll probably end up with much larger compound growth on your money than your principal which you contributed.”

    This is a common myth. Try doing the math. You’re only earning contributions from a much smaller starting point with a Roth, so even though earnings on a Roth aren’t taxed, the earnings themselves are proportionally lower.

  22. IRS pub 590 covers income limits for Roth IRA. It says if you make $114K or more and are single you cannot contribute to a Roth IRA, or if you are married filling jointly the limit is $156K – $166K.

    If you are over this amount and have maxed out 401(k) options, if you have non W-2 income sources such as consulting or a side business look into a SEP-IRA or Simple 401(k) that may allow you and a spouse to save pretax as much as $45Kish each. Note that this will be PRETAX so distributions are like a normal 401(k) — taxable and penalized if early.

  23. Yes, HELOCs are more expensive now — but if it’s an emergency fund or a bridge to your emergency fund then you’re not paying the 8%, unless you’re in some kind of emergency situation. So you’d have to do some risk analysis. Given X dollars I could invest in a semi-liquid investment, what kind of return do I get from that investment. Then compare that to your best assessment that you’d need to tap your emergency money and how much the 8% juice would cost from the time you tap until you can liquidate your semi-liquid investment.

    Like so many things, it comes down to evaluating risk/reward. Given my circumstances several years ago it was a no-brainer. Today I’m in a very different situation — cashflow is very high as I dump options regularly prior to semi-retirement.


  24. Jeff Law says

    On the subject of Roth vs Traditional IRA vs 401k vs other retirement investements — none is head and shoulders above the other. There are situations were any one can outshine the others.

    And this leads me to a point that I think people often miss — you diversify your investment portfolio, but you also should consider diversifying across the different types of accounts for tax purposes. If one particular retirement savings vehicle represents the likely best choice for you, that’s great, but you should still consider funding other vehicles just in case your long term tax status changes or the gov’t changes the rules on us. Hell, your tax status can even change during your retirement.


  25. I seldom see this aspect of Roths discussed, but the primary reason I am interested in a Roth is that you are not required to begin minimum disbursements at a certain age. If my other sources of retirement income are adequate, I like the option to keep the money in the Roth and allow it to continue compounding.

  26. Of course credit card debt should be transferred to a lower APR vehicle if available, but I’m assuming that is not an option for this discussion.

    I still would argue that retirement money should be funded with the highest priority. A debt problem shouldn?t be used as an excuse to underfund retirement – debt reduction should be a bucket that some of your money goes into each month, but it should not take away from your other buckets – you can?t ?catch up? your retirement savings later – you either get the funding in on time or forever give up that year?s contribution.

    I would agree that you should pay off credit card debt before fuinding an emergency fund – since your credit can be used in an emergency…

    So my priority would be: 401(k) match, Roth IRA, rest of 401(k), Pay Off Credit Card Debt, then Fund emergency fund. That’s where I’d direct “extra” money assuming you can afford the monthly interest charges on the CC debt.

    These are seperate buckets that should have money going into them simultaneously – not necessarily in chronological order. I.e. a higher percentage of money goes into the higher priority items, that doesn’t mean that you don’t pay off any credit card debt, just that its maybe 10% of your extra money as opposed to 100%…

  27. Alot of these comments are great, but no one talks about Mortgages. In my eyes, I see this as debt as well. Myself, paying for an interest only loan, makes me think I should put money into my mortgage to pay it off. Does anyone have comments on this? Or, is this something that should be dealt with when refinancing?

  28. I can’t fathom that so many people carry balances on credit cards (with the exception of zero interest cards). Live within your means people! I can’t think of any reason, besides an emergency, for an intelligent person to actually carry a balance on a credit card (again, the zero interest rate promotion is the exception). If you spend more than you make, you are guaranteed misery. If you spend less than you make, you will be much more able to achieve happiness.

    The reader asking the question needs to pay off the 4 grand in credit debt (unless it is at zero interest). Since he has 5 grand in savings, that leaves him with a surplus of 1 grand. This can serve as his emergency fund.

    If the reader can follow the above equation and spend less than he earns, then we can start talking about roth IRAs and 401ks. Until he gets sufficient savings to entertain in investments, it is a futile discussion.

  29. Michael read the original discussion, IMO mortgage debt unless your interest rate is sky high should not be paid off early – there are tax incentives to paying mortage interest, and money paid early becomes dead and loses 3% due to inflation every year, while if you invested it instead, your returns would grow. The house goes up in value the same amount regardless of your mortgage balance – leverage with tax incentives is a great thing. You also increase risk by paying off your mortgage, in a down market or if you lose your job – that money is inaccesible – if you had it invested you could draw upon it in emergency.

  30. The twist of having an interest-only mortgage is interesting, Michael. I think it’s still fair to say you shouldn’t pay any extra because of the reasons jt cites. You should find, though, that you have an extra $100-$200 a month (or more if you have a large mortgage) that you can invest long-term specifically to pay for your house in 30 years. $200/month for 30 years at 8% should be about $300k.

  31. Re: mortgages… the reason you want to pay it off (this applies ONLY for a personal residence that does not generate income for you) is to substantially reduce your expenses, and therefore the amount of income you will need. If you wish to retire or stop working (or reduce your work, or be “financially independent”…) the money you would need saved in cash to generate income to support a monthly mortgage payment would far exceed the cost to just pay off the mortgage.

    For example, let’s say you pay $1000/month on your mortgage:

    Various Monte-Carlo scenarios have shown that you should not spend more than 4-5% per year, then adjusting for inflation every year, when you are not working to pay your expenses. This means, at 4%, you would need to have saved $12000/.04 = $300,000 to generate the income to pay this mortgage for you. But at 6% interest, if you had a $300k mortgage, you would pay, just in interest, $1500/month. You may get a tax deduction for some of this interest, which may reduce the total cost to, maybe, $1200 per month, but this depends on the scenario for the particular person. Either way, though, note that in Jon’s calculation, he estimates his $200/month “savings” by going interest-only could net you the needed $300k to pay it off after 30 years. Or, instead, you would just get a 30-year fixed, and pay it off anyway. So, in his scenario, you would exactly break even and could pay it off, and with a 30-year fixed, it would be paid off no matter what. But if you go interest only, you are taking a huge risk! What if you spend the $200/month instead? What if you don’t earn 8%? Why play games with a sure thing?

    If your goal is to be “financially independent” and live on your investments, paying of a mortgage of your personal residence is a necessity.

  32. I should note that in order to get my lower 0% rate and offers for cards without balance transfer fees I had to borrow the balance of my debt at one point from my in-laws who financed the debt with a home equity loan. That worked for a year, in the meantime I continued using cards for daily expenses, making sure the balances were paid in full every month. When the variable interest rate on my in-law’s home equity loan kept creeping up, I bailed, applied for six of the best offers I had at the time (all with transfer fees around 3%) all at once so that I would have enough credit before the new accounts hit my credit record. I went down to 3% cost the first year for the transfer fees and have had no cost ever since.
    So a sort of reset was required to pull out of the nose dive.

  33. The Roth IRA still has an advantage over the traditional IRA and that is all the earnings from a Roth IRA is tax free, while a traditional IRA is taxed. So even if you are taxed more now that you will be when you retire you are still saving a lot more money with a Roth IRA.

    Let’s say you are 25 years old and you start a roth IRA. Also, the laws do not change and you can only put $4000 each year (in real life it will increase by $500 each year). You retire at 65 and can start taking the money out then. You get a 10% return each year. How much money do you have?

    $2,143,316.93. How much did you put in that was taxed? $160,000. So how much taxes did you pay if you were taxed at 33%? $52,800.

    Now you also open a 401k when you are 25 as well. Your employer will match the amount dollar for dollar up to $2000. So you put in $2000 and your employer puts in $2000 and you get a total of $4000 each year in your 401k. After 40 years when you are 65 and start to take out your money you get the same as the Roth IRA.

    2,143,316.93. But none of this money was taxed so how much will you pay in total taxes on this if you are taxed at 33%? $707,294.

    You will make $654494.59 more on your Roth IRA than you will on the 401k.

    I think this is why you must diversify your retirement holds to not only get the best return but also to protect against your tax liability.

    One thing is that if you employer offers the Roth 401k then take it! You can get the employer contributions, put $15,000 each year into the plan, and take out tax free earnings when you retire! I will post more about this on my finance blog.

  34. I am with Brian here on all counts. I was very surprised when I heard how many people carry balances, it is such a basic math. You cannot earn the interest that credit card charge risk-free, so until these are paid off, you risk loosing money. I think you have to pay off your credit cards and before you think about savings, especially long-term savings. The only exception is 0% – you can transfer all your balances there and pay off everything before 0% expires (also don’t use the same cards for purchases, or your payments will be applied to your transferred balance instead of purchases and you’ll still be charged interest on purchases). As to retirement – it is important, but if you have an emergency tomorrow or if you loose your job, 401K is not going to help much, but not having debt and having emergency fund (in that order) will. So if I had ever had high interest debt, my priority would be to pay it off ASAP (maybe this is the reason I’ve never failed to pay in full).

    As to the mortgages, in most cases the interest you pay is above what you get risk-free in the bank. If it is lower, then maybe you can hold off paying it. But as stock market returns aren’t guaranteed and having to pay mortgage is, I wouldn’t compare one with the other. By the way – I did once. At the hight of the internet boom around 2000, a friend suggested I sell some 50% of my stocks and pay off my mortgage. I said no because I was making more on the stock market. Then stock market crashed, and all these gains I could pay mortgage with evaporated, but I still had my mortgage. So when I sold my rental property, I paid off mortgage with gains. And while some stocks came back, many are still far below the level of early 2000s. So, had I followed my friends advice, I’d have more money now.

    By the way, the feeling of not having mortgage is great. It reduces your necessary living expenses by so much, that you feel a lot more comfortable in case something happens.

  35. Hey Brian/Kitty, here’s a simple one:

    You’re saving 10% of your income into an RRSP, but you have not yet accumulated an emergency fund (you’re young). You get a job offer half-way across the country that will increase you salary over the next year by about 11k (+ lower taxes), as you’re still young that’s like a 25% salary increase.

    Of course, without an emergency fund, you don’t have money to move. So what, do you just “live within you means” and not take the new job? “Yeah I’d love to go do my dream job for a great salary, but b/c no one is offering relocation expenses I won’t”

    And guess what, this is me! The bank isn’t going to give me a 5k loan just so I can move! So I call up the Credit Card, get a low-interest rate option enabled (for like $20/year) and pay for the move with the CC. I’m in the same boat as our author, I have like 10k in retirement saving and 4k on the CC. But I’m banking on the extra money to pay that down as well as the extra tax return money I receive in April (long-distance moves are tax-deductible here), to mitigate that difference.

    So I have a bunch of money on the card. This has nothing to do with “failure to live within my means”. The card is actually a debt leveraged against my current job.

    In Michael’s case, he is living within his means.

    He has more money in savings than in debt, so he’s in the black right now. Your response is “Hey obviously he should just cash out and pay off the debt”, but you’re totally ignoring the other factors. He’s not actually spending more than he makes. Obviously, the problem his that he’s spending more than he’s allowing himself.

    He can take a few different approaches, but purging his savings may be just as psychologically damaging as it is financially healthy. Taking the “easy math says” route completely ignores what’s actually happening here. Michael is bringing in money AND saving a chunk, but he’s spending more of the “non-saved” portions than he actually has. That 5k probably took Michael quite some time to save and by purging it, he’s fixing the problem, but not the habit that caused the problem.

    Michael is correctly saving a small chunk of his money and he should continue to do this b/c it’s a good habit. However, he should pay off the CC using his “spending” money so that he can learn to live “within his means” after meeting his savings. If Michael pays down the card from savings, he’s solved the problem but he hasn’t fixed the cause of the problem. If Michael pays down the debt from his cash, he’ll do both.

    The latter will cost him more money, but these numbers can be mitigated with zero interest cards and by rolling his balance along. At the end of the day however, Michael will now understand how to live with the money he has and he’ll have a greater appreciation for “the extra”.

    Money is not just numbers, it’s an extension of our emotional and personal health and it’s a series of habits. Michael has a good habit: saving. He needs to develop some more good habits and paying down the debt in cash over a year will enable him to learn another good habit. If the debt we’re something prohibitive (like 50% of annual salary), then maybe that plan would change.

    But Micheal is not obese here, he’s slightly overweight, don’t pull out the stomach staples and lipo-tubes, all we need is a little shift in diet and little more daily exercise. At the end of the run Michael will not only be healthy, he’ll know what it means to be there. That’s worth more than a couple hundred bucks in “bad interest”.

  36. JTMurdock says

    I know for me, once I get a new job, I am redoubling my efforts to pay off my credit card debts. As soon as I get a new job (I was one of the SunRocket employees that got laid off recently), my plan is to find a second job to work and pay off the $10k in credit card debt I need to get paid off to feel mentally better. Once that’s paid off, I’ll be able to give myself the ability to live without fear of money anymore.

  37. Hi Everyone, Well I was just in the same exact boat. I had $5,500 in savings (wamu 5%) and I had $4,000 on a debt management program. Since the amount of interest in the savings account was lower than the interest rate on my credit debt, I’m obviously losing money, so I just paid it off this week. I still contribute regularly to my 401K as well as my personal IRA, not as much as I should right now, but I can tell you the emotional relief of being free from consumer debt is amazing. The feeling of knowing that every dollar you make is yours now. So now all the money that was going to my debt is now added to what I was originally putting into savings which means I will replenish my savings account in the matter of a few months. Unfortunately it will all go to a wedding next year but that’s another story.

  38. Kevin, that’s a really good point about Roth IRAs. Many people (including me) assume that if the tax rate stays the same, it’s a wash. However, because there is a relatively low contribution limit, that’s not the case. Investing $4000 in a Roth IRA (post income tax) is equivalent to investing $5000 in a Traditional (if you have 20% tax rate)… but the problem is, you cannot invest that much since it is capped at $4000. Thus, investing in the Roth IRA is almost always a win.

    However, this analysis ignores what is done with the tax savings generated by the Traditional IRA investment. Since they are deductible, you have that extra money sitting around. A $4000 contribution should give you $800 (at that same 20% rate) of extra money. If that extra money is invested in a regular, taxable account, does it make up for the shortfall? Probably not, but I’d be curious to see what difference it makes.

  39. Gates VP, in the first situation you mention, you take a loan to make more money in the new job. Also, given the amount you need to move and the possibility to get a 0% loan and repay it before the interest goes up, it certainly makes sense to take a loan.

    In Michael situation, everything depends on the interest. If he uses a 0% offer, he can keep his savings until the period expires. However, it totally doesn’t make any sense at all to pay non-deductible 15% and earn taxable 5%. With this formula, his net worth goes down every month. He is wasting money.

    “However, this analysis ignores what is done with the tax savings generated by the Traditional IRA investment. Since they are deductible, you have that extra money sitting around. ”
    It is only deductible if your income is below a certain number. I personally has never been in a situation when I could deduct IRA contributions. So there is really no blanket statement as to when one is better than other – it depends on one’s income.

  40. Roth vs. Traditional IRA. My tax rate will definitly be lower in retirement but I think I have no chioce. I believe your MAGI number has to be below $50,000 ( Single person) in order to contribute to a Traditional IRA. Since its always higher than that, I believe I’m ineligible. If you know different, let me know…
    I always Max out my 401k first, then fully fund my IRA.

  41. I have a few comments, some of them may have already been stated.

    1) Firstly, on Kevin’s analysis of Roth vs Traditional IRA, I believe his calculation of the taxes paid on the Traditional IRA is incorrect. Not all of the money will be taxed at 33%. We have a graduated tax system. Assuming one takes out equal amounts each year, using 2006 as an example, the first 7500 will be taxed at only 10%, then 15% up to 30,650, etc. So, you really are paying your top tax bracket only on a small amount and it depends on how much you take out each year. Therefore the calculation is much more complicated. Isn’t this correct?

    2) For those of you whose income is too high to contribute to a Roth IRA, there are a couple things you can do. You can max out your 401K to bring down your income and also contribute to a healthcare spending account and/or a daycare spending account if you have children in child care. This may do the trick to reduce your income to the required amount, depending on how high your income is.

    3) Also in regards to the Roth IRA, starting in 2010 (if laws do not change before then) there will be NO income limit for Roth IRA conversions. This means, if you fund a traditional IRA now, or have a rollover IRA, you will be able to convert this to a Roth IRA regardless of your income. Granted you will have to pay taxes on it at the time of conversion (or over two years, I believe.)

    4) I want to reiterate what some already said about paying down credit cards. Everything you pay down is gauranteed return at whatever rate your credit card charges. In the stock market, returns are not gauranteed. So, this is one more reason to pay down the credit card. Also, I think the 0% options are risky. If you do what Jonathan does and put the money in a savings account, it is fine, but if you are using it for debt that you don’t have money to pay down, you are taking on many risks. If a payment is late, on any debt, they might raise your rate and if you miss transferring it before the 0% expires, you will owe interest for the entire time. Therefore, I recommend paying down your debt even if you have it on 0% if it is truly debt.

  42. “This means, if you fund a traditional IRA now, or have a rollover IRA, you will be able to convert this to a Roth IRA regardless of your income. Granted you will have to pay taxes on it at the time of conversion (or over two years, I believe.)”
    This is wrong on two counts:
    1. There is an income limit for conversions as well. I believe it is 100K a year – i.e. above where Roth IRA contributions start to phase out but below where they start to phase out completely.
    2. You only have to pay taxes on the original contribution amount if it was tax-deductible. If you don’t deduct IRA contributions, you only pay taxes on the interest when you convert.

  43. Joseph Sangl says

    I like it said this way. “Would you go borrow $10,000 on a credit card to invest in the stock market?”

    That really helps answer the question of “I have $10,000. Should I pay off the credit card or invest it?”

  44. Kitty — starting in 2010, there is no income limit for Roth IRA conversions as I stated.

  45. @Kevin, your math is extremely misleading in that the individual is not contributing the same amount of money into each account.

    Let’s take a better look at the situation (keeping your 10% growth, and 33% tax assumptions [and adding my biweekly contribution assumption]).

    $4K post tax / year into the Roth => $2.13M after 40 years.
    Total taxes paid on this money will be $52.8K.
    Present value after 40 years: $2.13M

    $4K/(1-0.33)+$2K /year into the 401k => $4.3M
    Total taxes paid on this money will be $1.1M.
    Present value after 40 years: $3.2M

    (Note on the 401k calc, I’m investing the pre-tax equivalent of $4K into the account, and considering the match a bonus. In this way, the post-tax cost to the individual is $4K, exactly what it would have cost the individual to contribute to the Roth.)

  46. Err… I slipped a wrong tax rate in there (proving that you shouldn’t do maths on the internets). The correct numbers:

    $4K post tax / year into the Roth => $2.13M after 40 years.
    Total taxes paid on this money (@33%) will be $52.8K.
    Present value after 40 years: $2.13M

    $4K/(1-0.33)+$2K /year into the 401k => $4.2M after 40 years.
    Total taxes paid on this money (@33%) will be $1.4M.
    Present value after 40 years: $2.84M

    Interesting factoid, take away that $2K/yr company match, and the present values of the two accounts differ by $17.88.

  47. Depends on your current credit rating. If you are not concerned (FICO Scores > 750) then migrate balances to 0% interest credit card and fund a retirement account. The earlier you fund the better. Otherwise (FICO Scores

  48. my post got truncated. Basically, it saves you money in a lot of ways to pay off credit cards. If the interest rate on those cards is 11% you would need a rate of return of at least that to break even, and you know how the market is right now.

  49. I can’t tell you what to do, but I can tell what I would do. Before you borrow and invest 10,000 dollars, i have one question for you. Can you afford to lose that 10,000 if that would happen. I wouldn’t personally invest borrowed money into the stock market simply because the stock market is a very emotional market. You owe 4 stacks on credit cards and you have 5 stacks. There is a rule when it comes to taking on debt. I know you are familiar with bad debt, but what about good debt. Now if you were to borrow 10 stacks, make sure someone else is paying off the debt for you via rental income or any other kind of residual or passive income. That is good debt. I haved studied the principles of finance and my education continues. Weight your options and figure out what is good for you not just today, but also think about the future. if you want better advice consult a financial advisor because everyone’s money situation is different.

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