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.
When deciding whether to pay down debt or to save for retirement, make sure you consider the following factors:
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.
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