Match first or card first? A worksheet for splitting spare dollars

Feelings are wonderful things for weddings, ball games and Thanksgiving. They are lousy things for deciding what to do with the last $700 in your checking account. And yet that is exactly how most families decide. One person says "I hate owing the card company, so pay it off first." Another says "my neighbor says never miss the match." Both feel strongly. Neither has run the numbers. The numbers, as it happens, give a clear answer, and the answer will not match your gut in every case.

So this post is a worksheet. It is a plain, repeatable calculation, with a worked example you can follow with a pencil. The voice here will stay out of the way, because the steps need to be exact. I'll save my opinions for the end. One note before we begin: everything below uses a made-up worker and made-up numbers. It is arithmetic, not advice for your particular situation, and your own plan documents and your own tax situation come first.

The cast and the numbers

Meet our hypothetical worker. She earns $60,000 a year. Her employer offers a 401(k) retirement plan with this match: the employer adds 50 cents for every dollar she contributes, up to 6 percent of her pay.

She also carries a $5,000 balance on a credit card with an interest rate of 22 percent a year.

Here are the first calculations, line by line.

• Six percent of her pay: $60,000 times 0.06 equals $3,600. That is the most the employer will match. If she contributes $3,600 over the year, that is $300 a month.
• The match on that: $3,600 times 0.50 equals $1,800. The employer adds $1,800 a year, or $150 a month.
• The card's yearly interest at a flat 22 percent: $5,000 times 0.22 equals $1,100. If the balance compounds monthly, as card interest does, an untouched balance would cost a bit more, about $1,218 over a full year. For the comparison we'll use the plain $1,100 and keep in mind that the true cost is a little higher.

She has $700 a month left over after all her regular bills, including the card's minimum payment. The question is how to divide those spare dollars.

Step one: compare the returns

The right way to rank two uses of a dollar is to compare what each one earns.

The match. For every dollar she puts in, up to the cap, the employer adds fifty cents the moment the money lands. That is a 50 percent return on day one, before any investment gain or loss (the $1,800 match divided by the $3,600 she put in is 0.50). It is not a promise about the stock market. It is free money from the compensation package.

The card. Every dollar she uses to pay down the card saves her 22 cents a year in interest. That is a 22 percent return, and it is guaranteed, because the interest is owed under the card agreement. No investment you can buy reliably promises 22 percent. This is a point worth underlining, because it is the argument for paying down expensive debt before reaching for extra investing.

So by raw return, the match at 50 percent beats the card at 22 percent. The gap is 28 points (50 minus 22). Her first dollars toward the 401(k), up to the match, beat the card.

Step two: check the catches

A calculation without caveats is a trap. Here are the catches that can change the ranking, and you should check each one before using the worksheet.

1. Vesting. Some plans make you stay for a period before the match belongs to you. If she is likely to leave before it vests, the effective return falls. Read your plan's summary.
2. The money is locked. Money in a 401(k) generally cannot come out before age 59 and a half without ordinary income tax and an additional 10 percent tax, with some exceptions. The card, on the other hand, can be paid down and borrowed on again. That is why the first step in the order is starter cash, so that a flat tire does not land on the card.
3. Tax effects. A traditional 401(k) contribution is made with pre-tax dollars, so her take-home pay falls by less than the full $300 a month. By how much depends on her tax bracket. To be safe, our example assumes the full $300 comes out of her spare dollars, which slightly understates the benefit.
4. The match rule itself. Match formulas differ. Some match dollar for dollar up to 3 percent, some use a sliding scale, and some pay in company stock or on a schedule. Read the formula in your plan documents, not the HR poster.
5. Rate changes. A card at 29 percent and a match of 10 cents on the dollar flips the ranking. We'll show the flip rule below.

Step three: the order of steps

Now put the pieces in order. For our worker the order is:

1. Starter cash. Build a small buffer first, in this example $1,000, so that a car repair or a vet bill does not go straight on the 22 percent card. This is not an emergency fund; it is a shock absorber. At $700 spare a month, it takes a month and a bit more: $700 in month one, $300 in month two.
2. The match. Raise her 401(k) contribution to 6 percent of pay, $300 a month, to collect the full $150 a month in matching money. In month two, once the buffer is full, $300 of her spare dollars goes to the plan and the remaining $400 starts attacking the card.
3. The card. From month three on, her spare $700 splits as $300 for the match and $400 for the card.
4. Extra retirement saving. Once the card is paid off, the $400 a month that was going to the card is free to be directed to more retirement saving, such as a larger contribution to the plan, or an individual retirement account, subject to the rules on contributions and tax treatment that you can check at irs.gov.

Let's see how step three plays out, in actual numbers. To keep it clean, count from her first $400 card payment and treat the balance as still $5,000 then, ignoring the small interest that builds during the buffer months. At 22 percent a year, the monthly interest rate is 22 divided by 12, or about 1.833 percent. On a $5,000 balance, the first month's interest is about $91.67 (5,000 times 0.01833). With a $400 payment, in the first payment $91.67 goes to interest and $308.33 goes to principal, leaving a balance of about $4,691.67. In the second payment, interest is about $86.01 and principal is about $313.99, leaving $4,377.68. In the third, interest is about $80.26, principal about $319.74, and the balance is $4,057.94. Each month, more of the payment goes to principal. Keep this up and the card is cleared in 15 payments, with total interest of about $732 (the 15th payment is smaller than $400). After that, $400 a month is free.

Compare that with the plan of paying only the minimum, which stretches the process out for years and adds up to far more interest. That is why step three says to attack the card with everything left after the match.

Step four: the flip rule

You can use this on any numbers. Here is the rule in words and in a formula.

Compute the match return: the employer's match rate (50 percent in our example). If the match is expressed as a share of pay, the return on the money you put in up to the cap is simply the employer's cents-per-dollar.

Compute the card return: the interest rate (22 percent).

Rank them. The higher return goes first. If they are close, tilt toward whichever is more certain and more flexible. The card payoff is certain and the money stays free. The match is certain only if you stay long enough to vest and if the money can stay locked.

Test it on another made-up worker. He earns $40,000, and his employer matches dollar for dollar up to 3 percent. That is $1,200 of his contribution (40,000 times 0.03) and $1,200 of match, a 100 percent return. He also has a card at 29 percent. The match wins by a mile, 100 percent against 29. Another worker has a match of 10 cents on the dollar and a card at 29 percent. The card wins, 29 percent against 10. The method is the same: write down the two returns and take the larger first, subject to the catches in step two.

The worksheet to copy

Copy this onto paper and fill it in with your own figures.

Then read the result: if line F is bigger than line H, the match comes first (after starter cash). If line H is bigger, the card comes first. Either way, starter cash is step one, and extra retirement saving waits until the card is gone.

A second worked example: when the card goes first

Fairness demands one case where the answer flips. Take a different hypothetical worker who earns $40,000. His employer matches 10 cents on the dollar, up to 3 percent of pay. He carries $4,000 on a card at 29 percent.

• Three percent of his pay: $40,000 times 0.03 equals $1,200 a year ($100 a month).
• The match: $1,200 times 0.10 equals $120 a year. That is a 10 percent return (120 divided by 1,200).
• The card's interest on $4,000 at a flat 29 percent: $4,000 times 0.29 equals $1,160 a year.
• Suppose he sends the same $1,200 to the card instead of the plan. That reduces the balance and saves about $348 in interest over the year at the flat rate (1,200 times 0.29 equals 348).

Compare the two uses of that $1,200. In the plan it earns $120 in match, and the money is locked up. On the card it saves about $348 and the money is not locked up in any way that matters, because the debt just goes down. Card first, by a wide margin. Once the card is gone, the match comes back to the top of the list, and he should start capturing it right away. Notice what changed the answer: not a preference, not a mood, but one line of the worksheet. This is why I like worksheets.

What if you cannot afford the full match?

Do the half version. Suppose our worker can only afford a 3 percent contribution at first. Three percent of $60,000 is $1,800 (60,000 times 0.03), a monthly contribution of $150. The match at 50 cents on the dollar is $900 (1,800 times 0.50), still a 50 percent return. The return per dollar is the same at any level below the cap, so even a partial contribution beats the card. Raise it when you can.

What this has to do with the bigger picture

I said I'd save my opinions for the end, so here they are. First, this is a good illustration of something conservatives believe about money: ordinary families are quite capable of running their own finances when they understand the numbers, and they do not need a government program to do it for them. A match is a private benefit, negotiated between a worker and an employer, and it works because it appeals to the worker's own interest. Second, it is a reminder that debt at 22 percent is a heavy chain, and that the single best financial move for many families is to get free of it. Third, retirement security does not rest on the government alone. Social Security is one leg of the stool. Your own savings and your employer's contribution are two others. For how the first leg works and what keeps it up, read How Social Security works and the promise built into its 1935 design. For where your pay goes before you ever see it, see a paycheck worksheet that shows where every dollar of your pay goes. For the cost of borrowing on the biggest purchase most families ever make, see a mortgage worksheet that shows what two points of interest really cost. And if you get a big refund every spring, read your big tax refund is a loan you made to the government for free and ask whether that money would work harder in the plan or against the card.

The tax code made this possible. Section 401(k) of the Internal Revenue Code was added by the Revenue Act of 1978, and it grew into the main way American workers save outside Social Security. The tax treatment is set by Congress, which is one more reason to pay attention to who writes the tax code. See Walking through Form 1040 from the first line to the refund for how it shows up on your return.

The bottom line

• Rank by return. A 50 cent match is a 50 percent return and beats a 22 percent card. A 10 cent match loses to a 29 percent card.
• Build a small starter cushion first so that the next surprise bill does not go back on the card.
• Capture the full match, then throw every spare dollar at the card until it is gone, then raise your retirement saving.
• Read your own plan's match formula and vesting schedule, and check the tax rules at irs.gov. The numbers here are made up, and yours are what count.
• Do the math once a year, or whenever your pay, your match or your card rate changes.