Funding your 401(k) when you're in debt

Photo: Philip Brewer

If there are two pieces of financial advice that get hammered more often than any others, they're "Get out of debt" and  "Put enough in your 401(k) to get any corporate match."  With times getting tough--making both debt reduction and saving seem more urgent than ever--how do you balance those two choices?

To figure out the right answer, you need a couple of pieces of information: You need to know what the corporate match on your 401(k) is and you need to know what the interest rate on your debt is.

Corporate match

During the good times, many companies offered a 100% match--one hundred cents on the dollar for the first three or six percent of your salary that went into the 401(k).  Others offered a 50% match.  Some had a tiered match, offering 100% for the first few percent and then a 50% match for the next few percent.  Get the rules from the plan documents or your company's internal communications regarding the plan.

Be aware that companies have been cutting their 401(k) matches, as a way to cut expenses in the face of the current hard economic times.  So, make sure you're getting the latest information, and also keep alert to future changes.  If the match changes, it could easily change the whole calculation.

Cost of debt

Track down all the kinds of debt that you've got--credit cards, personal loans, car loan, mortgage, etc.  You're looking for total cost of credit, so you not only need to know the APR, you also need to include any fees that you end up paying.

Credit card companies in particular have been raising the rates they charge.  They've also been becoming more aggressive with their use of the "penalty" rates that they charge people who have missed a payment--or simply have a high debt load.

What you need is the percentage rate you actually pay.  That number should be on every statement for a credit card.  For fixed-rate loans, it'll be in the loan agreement.


The comparison is straightforward, except for one detail:  Time.  You only get the corporate match once, but you go on paying interest on your debt until it's paid off.  So, you need to include that in your calculation.

If you can pay your debt off in one year, then you can just compare the rates--as long as the interest rate on your debt is less than the corporate match, put enough in the 401(k) to get the full match.  If the corporate match is 100%, only the most pernicious of payday loans will have an interest rate so high that paying off debt makes more sense than funding your 401(k).  Even a match of 50% is high enough that only seriously predatory loans will deserve to be paid off before funding your 401(k).  (This is why so many financial advisors just give the blanket advice to fund your 401(k)--a 100% or even 50% match is so good that it just swamps other considerations.)

If your debt is going to linger for two or three years, though, the calculation begins to change.  If you've got some high-rate credit card debt that's costing you 27% a year and that's going to take you two or more years to pay off, then attacking that debt would make more sense than funding a a 401(k) with a 50% match.  For a rough calculation, just multiple the interest rate by the number of years it'll take to pay off the debt.  That won't be exact (because the amount owed will decline over the period), but it'll be close enough that it's probably not worth going to any trouble to make a more accurate calculation.

If your debt is at 20%, then you're better off funding your 401(k) as long as you'll be still be able to get the debt paid off in 5 years (if you've got a 100% match) or 2.5 years (if you've got a 50% match).


There are certain limitations to the calculation. To begin with, you have to be careful about extending this sort of analysis to longer-term, lower-rate debt like mortgages or student loans, for two reasons:

First, once you go beyond a few years, the effect of the declining balance begins to be large--large enough that you can't just use the simple form of the calculation.  You can't just say that you should put your money into paying off your 6% mortgage if it's got more than 17 years to run.

Second, the corporate match is only one source of gain for your 401(k) contribution.  There's also the interest, dividends, and capital gains that the investments in your 401(k) can be expected to return (the difficult investment climate of the past few months notwithstanding).

Still, for shorter-term debt, the comparison is usually so stark that a rough calculation like this will give you the right answer.  If you've got a payday loan where you're paying a 246% APR, there's no question that you're better off suspending your 401(k) contributions until you get it paid off.  If you're paying ordinary consumer debt interest rates, you're probably better off going for the match.

A few other details:

  • Don't forget that you have go on making the minimum payments on each of your debts.  (Even a very high corporate match wouldn't leave you ahead if you defaulted.)
  • Allow for the fact that your 401(k) probably only lets you contribute whole percentages of your salary, and probably only lets you change the contribution level at certain times. 
  • If your 401(k) has a tiered match, you have to do the calculations separately for each tier--it may well make sense to fund the first few percent that get the higher match, but to not fund the next few percent that get a lower match. 

These factors don't affect the basic calculation, though.

Emergency fund

With credit card companies piling punitive interest rates on top of already high late fees, it has become especially important that you have an emergency fund.  Even if it means a delay in getting your debt paid off--even if it means giving up some sweet, sweet 100% match money--you simply have to have enough of an emergency fund to bridge something like a holiday weekend glitch in the direct deposit of your paycheck.  Ideally you'd want a much larger emergency fund, but the rock bottom minimum has to be enough to make one minimum payment on all of your debts.  Anything less than that leaves you too vulnerable.

The corporate match on a 401(k)--if you're lucky enough to have one--is often too good of a deal to turn down, even if it means paying off your debts more slowly, or taking longer to accumulate an emergency fund.  Under certain circumstances, though--such as a debt with a very high interest rate, or an emergency fund so small that you're exposed to any little cash flow hiccup causing you to miss payments and end up owing more in late fees and higher rates than you'd gained from the match--you need to take care of those items first.  Now you know how to figure which situation you're in.

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Guest's picture

These are good points but I want to make sure one thing is clear. This may only make sense in the short term while times are tough. There is no more powerful tool to make money than time. When you are deciding whether or not to pull your 401k funding go ahead and put the amount of money you will be losing into a 401k calculator (tons on Google). You will be surprised how much money a small amount now can become by the time you retire.

If you are young, even one year of contribution early on can cost you dearly come retirement, considering it would have had 40 or so years to compound. The difference between 1-2 years now is very small. The difference between the 42nd year and the 43rd year is very large. I hope that makes sense. Great tips Phillip.

Guest's picture

Great explanation, thanks. Luckily I don't have to make that choice quite yet, as my 401(k) is an 80% match and my educational debt is locked in <4%.

As Josh points out, the time value of money and compounding is another important factor-- even as a student, I contributed to my Roth when possible, and last year contributed enough to my 401(k) in order to get the full match, even though I had to save quite aggressively to do so. The small discomforts I had to put up with by being a poor student are far outweighed by the security that money will give me in 40 years.

Guest's picture

Maybe I'm being dim, but in what situations does it make sense to fund the 401(k) before debt payment if you have NO corporate match?

My husband has a good job, but it's a small company and they don't provide any matching funds. We have a small (1 month of expenses) emergency fund, and no debt other than our mortgage and home equity line. I'm a student, so currently my income is zero, and obviously I don't have a match, either.

We're trying to decide what ratio of our savings should go to: bulking up the emergency fund; fully funding our Roth IRAs; paying down the loans against the house (currently at 5.25% mortgage and 4.25% home equity line). Thoughts?

Guest's picture


You situation sounds like a good one to be in. You are truly almost debt free! Having no car payments must be nice!

I am not sure about your age, but the best thing to do is prepare for retirement. So many of our younger people are ignoring this fact.

First I would recommend building your emergency fund to 6 months for peace of mind. Then at least 10% into the 401k. An additional percentage should go to an IRA, ROTH if you qualify. If you going to have children then a small amount to a 529 college savings program is smart as well.

Remember your supposed to have 3 income streams for retirement and social security may not be there. 2nd we are living longer and longer so if you are 30 and retire in 30 years at 60, you will probably live to be 100 based on advances in science and medicine, so retirement money has to go further.

Depending on how much you have in the home equity LOC, you can create a comfortable schedule to pay that off say less than 5 years.

No matter what your age, you want to try and put the yearly maximum into your 401K, the sooner the better. Keep a higher interest savings account going to pay cash for cars, future home improvements, vacations and such. A credit card of your choice is also good to have on hand for shopping online or paying bills if your disciplined enough to pay it off at the end of the month. If your not disciplined then keep a card open and freeze it in a block of ice for emergencies!

As your comfortable, you can roll savings dollars in and out of high yield CDs and such.

All it takes is a little discipline. Ask around and find good financial planner as I am not one. Everyone's situation is different. I just hang around with very wealthy successful people and have picked up a couple things.

Guest's picture

What a thoughtful post! I don't know if I was as systematic when I was trying to make that decision when I was in debt. I just thought, if the company is going to GIVE ME MONEY for saving my own money, then that's a pretty good deal and I need to take it.

At my first company with a 401k, I got 50% match on 3% of my salary (maybe it was 6%, don't remember exactly), so I just made it a point to at least put in that 3%!
But, this is exactly the kind of information I was looking for then when I was trying to figure out if I could "afford" to do it. Thanks!

Philip Brewer's picture

There are at least three good reasons to fund your 401(k) even when there's no match:

  1. Tax deferal.  You don't have to pay income tax on the money contributed to the 401(k).  Also, investment earnings within the 401(k) are tax deferred until you withdraw the money
  2. Forced savings.  The "pay yourself first" notion is a powerful one.  Some people can live frugally, accumulate money in their checking account, and then invest it.  Most people, though, will save a lot more money if they arrange for the money to go straight to some investment account without passing through their checking account first.
  3. Low cost.  This varies from company to company, but many companies offer a good selection of low-cost investment options in their 401(k).

I actually wrote a post specifically on the topic of deciding between a 401(k), an IRA, and just plain ol' regular saving and investing called When NOT to put money in your 401(k).

Guest's picture

Outstanding, Phillip! Like Debt Hater said, I wasn't nearly as meticulous when deciding whether to take the 100% match. Free money is hard to pass up. Low interest consumer debt is not fun, but the match is an incentive worth taking in most cases. Seems like you covered all the bases on this one.