Should I Pay Off My Debt Before Saving for Retirement?
Question: Should I Pay Off My Debt Before Saving for Retirement?
I live on a tight budget and have some credit card debt. Should I get out of debt before thinking about contributing to my 401k plan?
Not necessarily. While some people will argue that you are better paying off debt before saving and investing your money, it may make sense to do both at the same time.
The Argument for Paying Debt First
The reason people advise that you pay off debt before you saving and invest your money is a logical one. It's a matter of weighing interest rates. If you are paying a high rate of interest on your debt, say 15% annual percentage rate paid by the average American these days, once you pay if off, you've just gained 15% that you had been losing. If you think of paying off debt as an investment, you just got a 15% return on your investment. Pretty good in any market. So it makes sense to put all of your money toward that until the debt is paid off, and you can go find some real return elsewhere.
Here is a helpful debt payoff calculator you can use to see how much you may be able to save on credit card interest payments over time by making extra payments on your debt obligations.
Why Common Sense Doesn't Always Make Sense
The problem with this argument is people don't always behave logically. If we did, most of us wouldn't carry so much debt in the first place. But carry it we often do. If you wait to pay off debt before saving for retirement but then never manage to pay off the debt, one day you may realize it's time to retire and you are completely unprepared. And, perhaps, still in debt. This is a position where many 30-, 40-, 50- and even 60-somethings find themselves these days. They are having to plan for retirement at the last minute.
The other problem is that some years your investments might return a lot more than 15%. Some years less, but if you stay invested the market for the long-term and keep making regular contributions, your money should at least be expected to see some growth and outpace inflation. Historically, the stock market has returned around 10% a year on average. Plus, your money compounds in a tax-deferred investment account such as a 401(k) or IRA. So it can grow even more quickly. Missing out on one or two great years could make a difference in your total savings.
To be sure, debt can grow just as quickly or more so. And I know I will get comments from readers who say debt is terrible and I'm encouraging it (I am not). But realistically speaking, you may be in and out of credit card debt many times throughout your life. If you are paying off the debt and simultaneously saving for retirement, you should end up on stronger footing than you otherwise would be.
When Saving for Retirement First Is an Obvious Choice
Saving for retirement regardless of debt is a no-brainer if your employer matches the contributions or a portion of the contributions that you make to your 401(k). With a 401(k) match you are getting an instant return on your money. Think of it as a bonus, a pay raise, whatever. It's easy money. So save at least up to the amount your employer will match; typically anywhere between 3% to 6% of your salary. An exception to the rule is if you plan on leaving your employer prior to being vested in those matching contributions.
But I say saving for retirement is a no-brainer anyway. Debt and retirement savings are two different things, so why consider debt in your decision to contribute to a 401(k) or IRA retirement plan? Whether you have an employer match or not, you have to take responsibility for your future retirement needs as well as your current financial needs. A retirement plan should be as much a part of the budget as your rent, car, cellphone and cable. Debt may come or go, retirement should always be a priority.
Still trying to determine how to prioritize your personal financial obligations? Here is an infographic that can be used to help you decide the most important area of your financial plan to focus on next.
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