You can use a variety of strategies to pay
off debt, many of which can cut not only the amount of time it will
take to pay off the debt but also the total interest paid. But like many
people, you may be torn between paying off debt and saving for
retirement. If you’re not sure you can afford to tackle both at the same
time, here are some of the factors you should consider.
Rate of Investment Return versus Interest Rate on Debt
Probably the most common way to decide whether to pay off debt or to
make investments is to consider whether you could earn a higher
after-tax rate of return by investing than the after-tax interest rate
you pay on the debt. For example, say you have a credit card with a
$10,000 balance on which you pay nondeductible interest of 18%. By
getting rid of those interest payments, you’re effectively getting an
18% return. That means your money would generally need to earn an
after-tax return greater than 18% to make investing the smarter choice.
That’s a pretty tough challenge even for professional investors.
Bear in mind that investment returns are anything but guaranteed. In
general, the higher the rate of return, the greater the risk. By
contrast, the return that comes from eliminating high-interest-rate debt
is a sure thing.
An Employer’s Match May Change the Equation
If your employer matches a portion of your workplace retirement account
contributions, that can make the debt versus saving decision more
difficult. Let’s say your company matches 50% of your contributions up
to 6% of your salary. That 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.
Plus, you know in advance what your return from the match will be; very
few investments can offer the same degree 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.Don’t forget the tax benefits of contributions to a 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.
Your Choice Doesn’t Have to Be All or Nothing
The decision about whether to save for retirement or pay off debt can
depend on 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,18% on your credit card debt, and your employer matches 50% of
your retirement account contributions. You might consider directing some
of your resources to paying off the credit card debt and some toward
your retirement account to get the full company match while continuing
to pay the tax-deductible mortgage interest.
Time is your best ally when saving for retirement. If you wait to start
saving until your debts are completely paid off, you might never start
saving. 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 with a lower
interest rate.
Bear in mind that even if you decide to focus on retirement savings, you
should make sure that you’re able to make at least the monthly minimum
payments owed on your debt. Failure to make those minimum payments can
result in penalties and increased interest rates.
Other considerations
When deciding whether to pay down debt or to save for retirement, make sure you consider 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.
- 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 you’re also building savings that could potentially be
used as a last resort in an emergency.
- 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.
Source: Mike Skolnick, CPA FPS, San Diego, CA