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I am retiring debt and saving money in my 401(k), but am I doing it all in the right order?

I am in a financial quandary and I need your advice. I am living paycheck to paycheck with some unique circumstances. My bring home pay a month is $2500.00 and my monthly bills (including mortgage, student loans, transportation, food, cell) equals approx. $2500 a month. Thus my net pay equals my expenses. I've been working to pay off some credit card debt and I am now down to $1600 in credit card debt (originally $7K as of November 2009). I also have started contributing 12% of gross pay to 401K and recently started putting $500 a month in savings account with ING. Altogether I am putting away about $1K a month. My problem is this -- Am I saving too much money in 401K and savings? With my current budget, I don't have enough to pay more than the minimum on my remaining two credit card debts. I am 34yr and I only have $25K in my 401K which is why I have increased my contribution this year to 12% instead of 6% and I had $0.00 in my savings account so I'm trying to put away 6 months worth of funds there. But am I doing too much or is it out of order somewhere? Any advice that you can give me would be appreciated.

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Bill's Answer
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Highlights

  • Consider temporarily stopping putting money into savings, until you have paid off your credit card debt.
  • Balance the risk-level of different retirement account plans.
  • Factor in your age, when choosing the level of risk for your accounts.

I commend you for your commitment to a) saving for retirement, and b) acting on your goal of setting aside six-months of savings. I would have fewer heartrending questions from distressed readers if more people followed your example.

I think you are taking all of the right actions. I have one suggested tweak or fine-tune to your plan, one thought, and one reassuring observation.

First, my suggested tweak is to temporarily stop setting aside your savings for two or three months so that you can bury the credit card debt. I suggest this because you are probably paying more than 10% APR on the credit card -- and probably a great deal more. This is in contrast to your savings account, which, given the low-interest earned in savings accounts these days, is likely earning peanuts. After you achieve debt freedom, resume your savings plan. After you reach your six-month goal, consider extending it to nine if you work in an industry with employment uncertainty.

My thought concerns the 401(k). I love them, and think it is great you are setting aside 12% of your income to your retirement. Consider splitting your 401(k) into three unequal pieces. Younger workers (say age 35 or less) should invest the largest part of their 401(k) pool in high-risk funds. Smaller pieces should be evenly split between balanced and low-risk funds. Middle-age workers should balance their 401(k) pool over all three fund types. Workers nearing retirement age should move their funds into low-risk, cash-based funds that do not fluctuate with the stock market.

Therefore, if you are a younger or middle-aged worker, be aggressive and choose overseas and small-cap funds. This is marathon and you can ignore short-term fluctuations in the stock market indexes.

My reassuring observation is this: Once you get your debt retired and your savings banked, you will feel less like your are living paycheck-to-paycheck because you will have confidence knowing you have a nice cushion to live on.

I hope this information helps you Find. Learn & Save.

Best,

Bill

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