How do I calculate the benefit of contributing to 401K vs paying off consumer debt?

Question

I have a ~$15,000 loan with a 6% interest rate.

My company matches half of my 401K contributions up to 6%, and I am in a 25% tax bracket. I currently contribute 15% of my income to my 401K.

How do I calculate whether it's better to pay more toward the loan, or put more into the 401K?

My rough attempt at the math:

Suppose $X goes to a 401K. After a year this grows to ~1.07 * $X. Profit is ~0.07 * $X

Suppose rather that $X goes towards debt. I lose %25 to tax. I save 0.06 * %X on interest. Profit is 0.06 * $X - 0.25 * $X. Therefore it makes more sense to invest in the 401K.

But I'm not sure if I'm making good assumptions.

Answer 1

Suppose $X goes to a 401K. After a year this grows to ~1.07 * $X. Profit is ~0.07 * $X

Suppose rather that $X goes towards debt. I lose %25 to tax. I save 0.06 * %X on interest. Profit is 0.06 * $X - 0.25 * $X. Therefore it makes more sense to invest in the 401K.

With the 401k contribution there is an up-front tax savings, but the withdrawals will be taxed as ordinary income, so it doesn't make sense to ignore the tax on the 401k altogether.

At the end of the day, it's primarily about the employer match and the performance of your 401k. Your 401k could easily do better than the 6% interest rate on your loan, but the 6% interest is guaranteed. Giving up the 50% employer match to clear up debt at 6% interest makes no sense. What might make sense is reducing your 401k contribution to 6% to maximize the employer match and using the rest to pay down the loan.

Any analysis about which is mathematically better will hinge on assumptions about future tax rates, potential 401k growth rates, and number of years before you start withdrawing from your 401k. Personally, 6% is a significant enough rate that I would like to have it off my books sooner than later, even if the market is performing a little better than that, it's a sure 6%.

Answer 2

You are forgetting the company's match - that gives you an immediate 50% gain, which beats anything else, even ludicrous credit card interest rates.

Otherwise, you are right - once you take advantage of the maximum employer match, pay off your credit cards first, and don't rack them up again. Then start saving the max in 401k, then pay off consumer credits. And don't make any new ones.