Why we are opting for 401K over debt reduction…

Normally the mantra for personal finance is: pay off debt, and then save. I agree with this about 95% of the time, but sometimes financially it does not make sense. For the upcoming 2012 tax year, we are opting to put money in 401K vs. paying off debt.

The reason we have elected this approach is primarily tax consequences and the 401K match with Mr. Super Frugalette’s company. There is another reason for this approach. We have achieved our target amount for our emergency savings and all the factors we consider for our “emergency savings” account.

Our tax goal every year is to break even—we never hope for a refund and we do not desire to owe any money. In order to calculate this amount, I prepare a “fake” 2012 tax return. I put in the amount of his annual salary, less the amount that we pay for insurance which is not taxable. We take the standard deduction which simplifies the calculation. I check the tax amount and then apply the child tax credit we receive. In 2012, since we are adding a fourth child, we receive another exemption, plus another child tax credit. Thus, I am able to project our taxes. For our state taxes, I use the same approach. I then adjust the W4 so that the correct tax amount is taken out.

Mr. Super Frugalette is currently receiving a monthly “bonus” for tackling an extra project at work. It is causing him to put in extra hours, but it is pretty impressive that the company is rewarding him for his effort. The monthly bonus is scheduled to end in July, but could potentially be continued for a couple more months. When I calculated our taxable income with the monthly bonus, our taxes went way up. I did some calculations. We only received 78% of the “extra” income because 22% went directly to taxes.

We were contemplating paying down some extra debt, but only applying 78% of the money to the debt seemed a bit depressing. The debit is credit card debt, but it is a closed account with a fixed rate. Thus, it functions like a personal loan. We still have to pay the interest, so paying it off early is not going to save us money. We have no other credit cards and are able to keep our expenses within budget so this credit card balance is not growing, but shrinking with each monthly payment.

However, putting the funds into 401K does save us some money. We will save $1,500 in taxes, just by depositing the money into 401K. Mr. Super Frugalette’s company will match up to 50% of an employee’s 401K contribution up to $4,500 at the end of the fiscal year depending on an employee’s performance. Thus, by investing in 401K there is the potential to earn “incremental” income from his employer. Vesting is an issue, but Mr. Super Frugalette has worked for the company for over three years and intends on being there for another two years at the minimum, so we do not have to be concerned about vesting. The company is growing at an exceptional rate, so job security is not an issue either.

However, as nice as it is to put money into 401K…and this is the first time that Mr. Super Frugalette has been able to participate in 401K, we still have the sour taste in our mouth of the debt. We have explored one additional option – the end of year bonus. Mr. Super Frugalette and everyone else in the company has received an end of year bonus every year. The amount has varied significantly. Thus, we do not “bank” on the bonus.

This bonus affected my tax calculation for our 2011 taxes. We owe money. However, I cannot complain because we would not owe money if he did not make money. Thus, for 2012 if Mr. Super Frugalette does receive a bonus, then we will allocate the bonus to the reduction of the debt and incur the 22% tax rate as well.

One other aspect that is worth mentioning that influenced our decision – IBR. For those of you who are unfamiliar with IBR it stands for income based repayment. Both Mr. Super Frugalette and I have significant student loans. Our initial plan for the student loans was that when Mr. Super Frugalette graduated with his Ph. d, both he and I would have a two income household. We would dedicate the majority of one of the incomes to paying down student loan debt so that we could transition to a one income household.

Just months after defending his Ph. d, I gave birth to our second child. Our second child lacked oxygen at birth and on account of that is severely disabled. Our “plan” for the two income family was eliminated since our son’s cares required one parent to be home full time. Considering that we are a one income family, with student loan debt that well exceeding 100K combined, paying our loans at even an extended payment plan of 25 years was impossible. We simply could not afford the payment.

We applied for IBR and were given a monthly payment for both of our loans that reflected a payment that our income and family size could afford. The premise of IBR is that you apply each year with your tax return (or other appropriate documentation) and your family size. You are given a payment amount that is reasonable for your income and family size. If you participate in IBR for 25 years and are in good standing, then any residual amount of the loan will be forgiven.

We realized that by putting money into 401K, our income would be reduced on our tax return and that amount would be used to calculate our IBR payment. If we did not put the money into 401K , our IBR payment was slated to be increased by $200-$300 a month, which is a huge increase and a huge hit for our budget.

After many conversations and much research we decided that opting for 401K over debt reduction is the best financial strategy for 2012. Do you agree or disagree with our approach?