If you are like the vast majority of Americans, you probably have some sort of debt. While there is nothing wrong with having some debt, you certainly want to pay it off as quickly as possible so you are no longer paying the interest. But, we all know how important it is to save for retirement. Especially because the more you save now, the more you will benefit in the future. So which one should you do? It can be hard to decide if you should pay off debt or save for retirement, especially if you don't think you can afford to do both. There's no right answer on what you should do, but there are some factors you should consider when deciding if it is better for you to pay off debt or save for retirement.
Rate on Investment vs. Debt Interest Rate
One of the most common ways to decide whether to pay off debt or save is to consider if you earn more of the after-tax rate of return by investing or by paying off the debt. For example, let's say that you have a credit card with a $10,000 balance and a interest rate of 18%. By paying off that debt and getting rid of those interest payments, you're effectively getting an 18% return on your money. This means that to make it better to invest, you need to earn an after-tax return of greater than 18%. Pretty tough to do, even for the most experienced of investors.
And that is before you consider the fact that your return on investment is anything but guaranteed. In general, the higher the rate of return, the greater the risk. If you make investments rather than pay off debts and your investments incur losses, you will still have your debts to pay, and you won't have earned any gains or returns on your investments. By contrast, the return that comes from eliminating high-interest-rate debt is a sure thing.
Understand Your Employer's Match
When deciding if you want to pay off debt or save for retirement, consider your employer's retirement account contributions. If your employer does a match of your contribution, it can make your decision to pay off debt or save a little more complicated. Let's say your company matches 50% of your contributions up to 6% of your salary. This means that you're earning a 50% return on that portion of your retirement account contributions.
If surpassing an 18% return from paying off debt is a challenge, getting a 50% return on your money simply through investing is even tougher. Assuming you are eligible and meet all of the plan's requirements, you know in advance exactly what your return from the match will be. Not many investments can offer you that level of certainty. That's why many financial experts argue that saving at least enough to get any employer match for your contributions may make more sense than focusing on debt.
And don't forget the tax benefits of contributing to your workplace savings plan. By contributing pretax dollars to your plan account, you're deferring anywhere from 10% to 39.6% in taxes, depending on your federal tax rate. You're able to put money that would ordinarily go toward taxes to work immediately.
It Doesn't Have to Be One or the Other
The decision about whether to pay off debt or save for retirement can be affected by the type of debt you have. For example, if you itemize deductions, the interest you pay on a mortgage is generally deductible on your federal tax return. Let's say you're paying 6% on your mortgage and 18% on your credit card debt, and your employer matches 50% of your retirement account contributions. You might consider directing some of your available resources to paying off the credit card debt and some toward your retirement account in order to get the full company match, and continuing to pay the tax-deductible mortgage interest.
Another good reason to consider splitting your funds and putting your money towards retirement and paying off debt is that time is your best ally when saving for retirement. If you say to yourself, "I'll wait to start saving until my debts are completely paid off," you run the risk that you'll never get to that point. Even though you might have good intentions for paying off your debt, life happens and it could take you longer than you initially expected. Putting off saving also reduces the number of years you have left to save for retirement. And when it comes to saving for retirement, time is your best friend.
It might also be easier to address both goals if you can cut your interest payments by refinancing that debt. For example, you might be able to consolidate multiple credit card payments by rolling them over to a new credit card or a debt consolidation loan that has a lower interest rate. Whatever you decide, make sure you have the funds available to at least pay the monthly minimum on your debt. If you can't make your minimum payment, you may face penalties, increased interest rates, and other factors that make your debt situation worse.
Other Things to Consider
When deciding whether to pay off debt or to save for retirement, make sure you take into account the following factors:
Having retirement plan contributions automatically deducted from your paycheck eliminates the temptation to spend that money on things that might make your debt dilemma even worse. If you decide to prioritize paying down debt, make sure you put in place a mechanism that automatically directs money toward the debt--for example, having money deducted automatically from your checking account--so you won't be tempted to skip or reduce payments.
Do you have an emergency fund or other resources that you can tap into in case you lose your job or have a medical emergency? Remember that if your workplace savings plan allows loans, contributing to the plan not only means you're helping to provide for a more secure retirement but also building savings that could potentially be used as a last resort in an emergency. Some employer-sponsored retirement plans also allow hardship withdrawals in certain situations. For example, payments necessary to prevent an eviction or foreclosure of residence, as long as you have no other resources to tap. (Remember that the amount of any hardship withdrawal becomes taxable income, and if you aren't at least age 59.5, you also may owe a 10% premature distribution tax on that money.)
If you do need to borrow from your plan, make sure you compare the cost of using that money with other financing options, such as loans from banks, credit unions, friends, or family. Although interest rates on plan loans may be favorable, the amount you can borrow is limited, and you generally must repay the loan within five years. In addition, some plans require you to repay the loan immediately if you leave your job. Your retirement earnings will also suffer as a result of removing funds from a tax-deferred investment.
If you focus on retirement savings rather than paying down debt, make sure you're invested so that your return has a chance of exceeding the interest you owe on that debt. While your investments should be appropriate for your risk tolerance, if you invest too conservatively, the rate of return may not be high enough to offset the interest rate you'll continue to pay.
Regardless of your choice to pay off debt or save for retirement, the most important decision you can make is to take action and get started now. The sooner you decide on a plan for both your debt and your need for retirement savings, the sooner you'll start to make progress toward achieving both goals.
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