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Should You Pay Off That Debt?

Tomorrow is the last day of the tax season, so I wanted to write this post, even though it has nothing to do with miles and points. First, a disclaimer. I am not a financial planner or advisor of any sort. I am just very opinionated and like to give advice, which is why I started writing this blog.

Let’s say you are a middle class family, where a husband is the primary breadwinner. He just started a job where he makes $50,000 per year. The company offers a 401(K) option and will match 50 percent of his contribution on up to 6 percent of his income. At the same time, your family is trying to pay off debt of $3,000 with an interest rate of 14 percent. Also, you don’t currently have any emergency savings. You have a surplus of $3,000 per year and not sure what to do with it.  So, your choices are:

1) Pay off your credit card debt.

2) Put money in an emergency fund.

3) Contribute to your 401(K).

Many people would tell you to go with the option number one, or possibly split the money between an emergency fund and credit card debt.  My advice — and it’s only my opinion — is that in this particular case, you should be a contrarian and go with the option number three.

But, wait! I have always said that debt is evil. Yes, it is. But in this case,you would be walking away from making a 50 percent interest return on your money and possibly more, if you qualify for Saver’s credit, which I talked about before. BTW, tomorrow is the last day to make an IRA contribution for 2013.

Even though 401(K) is the money you probably won’t see for many years, it simply makes no sense to pass on such an amazing opportunity. One of the misconceptions out there is that your 401(K) money would be put into a stock market. Most of the time that is not the case, as you have an option to put it in a much safer retirement vehicle, such as Money Market fund et cetera. Check with your HR rep for more details.

So my advice is to always max out your 401(K) contribution up to your employer’s match. In this case, it would be $3,000 per year, or 6 percent of the husband’s income. What you do after that is up to you. If you have no debt,  my suggestion is to open a Roth IRA in the spouse’s name and contribute $2,000 per year.

Many middle class families will qualify for 10 percent or 20 percent Saver’s credit on that amount, depending on their AGI (adjusted gross income).  In fact, I recommend you put in $2,000 in a Roth IRA even before funding your emergency savings. That’s because any original contributions to the Roth IRA can be withdrawn without penalty at any time. In a way, it will become your emergency fund of sorts. Make sure to put it in an FDIC-insured account to protect your principal.

My emergency fund consists of 3 layers:

1) Regular savings (25 % of my emergency fund)

2) Roth IRA in a CD at an FDIC-insured bank (50 %)

3) Roth IRA in a Vanguard account, invested in a Vanguard Total Bond Market Index Fund  (25 %)

There is a chance of losing money with the last one, but I have other 2 layers I would dip into first. The total in all accounts equals about 1 year of my husband’s salary. I would really prefer not to touch my Roth IRA accounts though, since when you do that, you will not qualify for  Saver’s credit for the next 2 years.

Back to the  example at the beginning of my post. The family is in debt that charges 14 percent interest, so the priority would be to pay it off ASAP, even before putting money in an IRA and getting 10% Saver’s credit (they won’t qualify for 50% or 20% Saver’s credit bracket because of their AGI).  They could apply for a card with a 0% balance transfer offer. They would also be wise to cut back on their expenses,  and try to channel the money towards paying off the debt. And of course, any extra credit card spending  should be put on hold.

Many websites recommend cutting out any vacations or fun. I actually think that goes a bit too far. Naturally, you should not be splurging on a trip to Tahiti, but some sort of entertainment is a must. Otherwise, you run a risk of getting depressed and giving up on the whole “getting out of debt” plan altogether.

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Author: Leana

Leana is the owner and founder of Miles For Family. She enjoys beach vacations and visiting her family in Europe. Originally from Belarus, Leana resides in central Florida with her husband and two children.

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3 thoughts on “Should You Pay Off That Debt?

  1. You may want to reconsider the bond piece. Not advising you but just telling you to think about bonds, generally they will go down when interest rates rise. Interest rates have dropped for approx the last 30 years. Its about time for interest rates to go the other way which means your bonds lose value. For a flyer and people cursing my name on here check out investing in a Russia index fund like RSX. If you want to buy low Russia is extremely cheap which cuts your risk. You must also consider inflation which will slowly devalue your CD and fixed investments.

  2. Jacob, thanks for stopping by! As I said, I’m not a financial planner and this was in no way an advice for others to follow.
    I absolutely agree about the danger of bonds in the current interest environment. However, I don’t feel comfortable putting my emergency fund in stocks. I didn’t mention it, but I also have a Traditional IRA, evenly split between VHDYX, VIPSX and VGTSX. I feel, those will balance out any swings in bonds. If I have to, I will dip into my Traditional IRA instead, especially if it has performed nicely up to that point.
    I may pull out of bonds after the first interest hike, though, and put my Roth IRA in a money market fund. Frankly, I prefer not to touch IRA’s period, that’s the goal.
    As far as Russia index fund, I will look into it. Thanks for your advice. I do like to be a contrarian when it comes to investing, but nothing too crazy. No gold stocks for me!

  3. Pingback: On Last-Minute Tickets, Maldives and Skinny Supermodels | Miles For Family

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