According to the Federal Reserve Board, nearly a third (31%) of U.S. adults say they had no savings or pension to help them afford retirement and a quarter didn’t know how they would afford the golden years. Not only that, but according to a 2014 survey conducted by creditcards.com, one in five Americans believe they will die while still in debt.
Those are two very scary statistics! With that in mind, many are pondering whether it is more important to pay down debt or save for retirement? Just as with all other financial matters, there is no one answer that’s right for everyone, but there are some general factors to consider when making your decision.
Rate of Investment Return versus Interest Rate on Debt
Probably the most common way to decide whether to pay off debt or to invest any discretionary cash is to consider the opportunity cost; that is, can you earn a higher after-tax rate of return by investing than the after-tax interest rate you pay on your debt?
For example, say you have a credit card with a $10,000 balance on which you pay nondeductible interest of 15%. By getting rid of those interest payments, you’re effectively getting a 15% return on your money. That means your money would generally need to earn an after-tax return greater than 15% to make investing a smarter choice than paying off that particular debt.
However, the decision about whether to save for retirement or pay off debt can sometimes 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.
Something to keep in mind too is that investment returns are anything but guaranteed. In general, the higher the rate of return, the greater the risk. If you make investments rather than pay off debt and your investments incur losses, you may still have debts to pay but you won’t have had the benefit of any gains. By contrast, the return that comes from eliminating high-interest-rate debt is a sure thing.
An Employers match may change the equation
If your employer matches a portion of your workplace retirement account contributions, that can make the debt versus savings 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 a 15% return from paying off debt is a challenge, getting a 50% return on your money simply through investing is highly unlikely. This may make saving at least enough to get any employer match for your contributions a higher priority than focusing on debt.
And don’t forget the tax benefits of contributions to a workplace savings plan. By contributing pretax dollars to your workplace retirement plan, you’re deferring taxable income which, depending on your federal tax rate, could be anywhere between 10% to 40%. You’re able to put money that would ordinarily go toward taxes to work in your retirement account immediately.
A Life of Balance
A successful strategy will most likely include a mix of paying off debt and saving for retirement. For example, let’s say you’re paying 5% on your mortgage and 15% on your credit card debt, and your employer matches 50% of your retirement account contributions up to 6%. You might consider first meeting your company contribution match while continuing to pay tax-deductible mortgage interest, and then putting extra discretionary dollars toward your credit card debt.
There’s another good reason to explore ways to address both goals. Time is on your side 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, because your good intentions about paying off your debt may falter at some point. Putting off saving also reduces the number of years you have left to save for retirement.
When deciding whether to pay down 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.
- Do you have an emergency fund or other resources that you can tap into in the event that 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 situation. Some employer-sponsored retirement plans also allow hardship withdrawals in certain situations if you have no other resources to tap. For example, payments necessary to prevent an eviction from or foreclosure of your principal residence.
- 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.
Talking to a Financial Planner can help you sort through the options available to your to reduce debt and also prioritize retirement savings. But regardless of your choice, perhaps 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. Reilly Financial Advisors is a fee-only Registered Investment Advisors. Our team of professional advisors can help you both define and achieve your individual financial goals.