Should I save for retirement or use my extra income to pay off debt? That is a question that many Americans are currently faced with. There is no question that debt has become a huge problem for most people in this country. In fact, I believe that the best way to financial freedom is to eliminate all debt!
However, most Americans have also neglected their retirement savings as well. According to a recent article by Market Watch:
The gap between what Americans need for retirement and the amount they have saved is a staggering $6.6 trillion. The $6.6 trillion retirement income deficit amounts to about $90,000 per household if you count all 72 million households ages 32 to 64, though that figure includes even those who have enough saved for retirement, said Anthony Webb, a research economist at Boston College’s Center for Retirement Research.
This means that many of us will be in serious financial trouble once the time for retirement comes around. The only way to correct this is to start saving today, or forgo retirement and work until you are physically unable.
So then the question becomes…which is more important? If you are in debt and behind in your retirement savings, where do you stick your cash? Do you hold off on contributing to retirement accounts until you are completely debt free? Should you instead max out your retirement accounts and take much longer to get out of debt? Is there a logical, orderly way to combine both?
Pay Off Debt Before Saving For Retirement
There are two very strong arguments for why you should completely get out of debt before contributing to your retirement accounts.
Guaranteed Rate Of Return
If you concentrate on getting out of debt, then you guarantee yourself a rate of return on your money that is equal to the rate of interest on your debt. For instance, if you are currently paying 20% each year on your credit card debt, then by paying it off, you guarantee yourself a 20% annual rate of return! That sounds like a great investment to me!
The same is true for any other type of debt for which you pay interest. Even though the interest rate on a house or a car is generally lower than that of a credit card, and the fact that they are amortized means that more of the interest is paid in the beginning of the loan, there is still significant savings to be had by paying them off early.
The second argument for paying off your debt before saving for retirement, is that you gain financial freedom! Being debt free means that you are now free to allocate your money any way you wish – after covering your living expenses, of course.
Fund Your Retirement Accounts Before Focusing On Debt
The Power Of Compound Interest
Simply stated, compounding interest describes what happens when interest is calculated on a principal amount of money, and then that interest is added to the principal and now interest will be calculated on this new higher amount. For instance, if you save $10,000 and it earns 10% interest over the course of a year, you have earned $1,000, meaning you now have $11,000 in your account. If we are dealing with compound interest, the next year will begin with a new principal amount of $11,000 and your 10% interest will now earn $1,100 in the second year!
Since you aren't going to withdrawal any money out of your retirement account, each year the returns from the previous year are invested as well, so your account continues to build even if you do not add new funds [Note: The actual mechanics of investment accounts work a little differently, but the basic result is still the same].
So each year that you neglect to save for retirement, you are not only losing out on what you would have contributed for that year, but you are also missing out on the compound interest on your contribution for the next 20 to 40 years!
Tax Deferred Accounts Have An Annual Contribution Limit
If you wait until you are completely out of debt before you contribute to your retirement accounts, you will still be subject to the IRA contribution limits or the 401k contribution limits for that particular year. So even if you now have $40,000 to contribute to your retirement in 2015 because you neglected retirement savings in the previous years to get out of debt, you will still only be able to contribute $16,500 to your 401k and $5,000 to your IRA (assuming that the limits don't change between now and then, and you are under 50)!
You May Be Missing Out On Free Money
If your employer offers a 401k employer match, then by refusing to contribute to your 401k until you get out of debt, you are passing up on free money! You could actually be turning away thousands of dollars each year because you are so focused on debt! If you make your retirement planning a priority, then you can avoid giving away money!
Save For Retirement While Getting Out Of Debt
Here is my suggestion for most people. There is no rule that says you have to go “all or nothing” when it comes to allocating your money. Put some of your money toward debt repayment, and put some toward retirement saving.
Because debt has such a negative influence on our financial freedom, happiness, and even weight, my vote is always to eliminate debt. However, because of the prospect of free money for retirement, I can't imagine passing on my 401k contributions.
So, if you are in debt and have a chance to contribute to a 401k, do it – at least contribute enough to get the full employer match. Then put the rest of your money toward debt repayment.
Some may ask…why not contribute more? Good question. Well, do you remember that compound interest that we talked about? If you are in debt, chances are that it is working against you. You are not only charged interest on the principal amount, but also on any previously accumulated interest! That means that you must make getting out of debt a top priority – right below getting free money!
What are your thoughts? Tell us what you think about the debt vs. retirement debate in the comments!