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.
Financial Freedom
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!
The one thing this article doesn’t account for is the percent savings associated with maintaining debt and saving in tax deferred accounts. While no retirement account rivals the 20% credit cards and the fact that you lose freedom should there be a change to cash-flow, once those are paid off, this becomes a discussion of numbers, some less noticeable than others. If I have 5% student loan debt and I am earning 5% in an IRA then it seems like a wash. But, since the interest on the loan is deductible and there are tax benefits associated with traditional or Roth IRAs, it makes more sense to maintain the debt. If you can handle the mental stress of maintaining debt.
It’s true that credit cards usually present the easiest comparison because of the high interest rates. But I also have an intense hatred of debt, because of the problems that usually come with it!
Also, if one was to lose their job or face some other financial emergency, then being out of debt would be the optimal position.
I agree with the idea of contributing enough to your workplace retirement plan to get the full match (it’s the easiest money you’ll ever make) if you can do that AND pay more than the minimums on your debts. If you can’t do both, focus on the debt.
I agree. I hate debt, so I would be willing to pass on the free money if I couldn’t pay more than the minimums!
Here’s something to consider:
Let’s assume that 5% of your salary is $3,000. You should ALWAYS put this into an employer-matched 401K. Assuming you are vested, you could withdraw the employer match portion, pay the penalty (10%) + the taxes you’d owe (probably around 25%). The other 65% you withdraw could be used to pay off the debt that you originally didn’t pay because you contributed to the 401k. You could also take this further and put the money in JUST to get the match, and then pull all of the money out (your contribution + the employer match) and pay taxes and penalties on it. While the 10% penalty is a real killer usually, if you are using the 401K fund to get your employer’s “free” match money, it’s a small price to pay to get the additional cash.
Some plans will restrict you from withdrawing the employer match portion while you are still an employee, but not all do.
Fred
I agree Khaleef, I always counsel people to pay off debt first, but to contribute at least a little something to their retirement account(s) whenever possible… it is a very necessary habit to form, even if the amount is only $1/month.
That is very sound advice. As you said, forming the habit is early is just as important as the initial investments!
I like the idea you propose – contribute enough to receive the employer match, and then throw everything towards debt.
Personally i just can’t stand having debt, so I’d have a bias towards paying off the debt as quickly as possible, and then working towards the retirement savings. Of course I wouldn’t have any problem with someone wanting to save something for retirement while paying off debt, I’d just make sure a majority of it was going towards paying off that anchor holding you back – debt.
I hate debt as well! If one doesn’t have enough to do both, then they should try to cut expenses. When that fails, focus on getting out of debt!
Hi, Khaleef,
You describe a tough situation.
However, one key you haven’t mentioned is the person/family’s spending behavior.
Have they now learned to stay out of debt?
If not, the credit card debt they pay off this month will return. The way some people spend, pay, spend, pay etc will almost guarantee they arrive at age 65 still owing money.
If they have no retirement savings, they’ll be that much worse off.
If they now save for retirement instead of paying down debt, they’ll at least have some retirement savings.
They also need some emergency savings. It’s great to not owe any money, but if you’re then laid off, you’ll still cash money for food, shelter and utilities.
I believe that people who are too far in debt should channel that desperation into figuring out how to make more money. Worked for me.
You make a good point. I usually approach these articles assuming that if someone is reading it, then they are already trying to get their financial household in order – but that is not always the case.
I like the idea of increasing income – that is something that I’ve learned over the last year. You can only cut your expenses so much, but your income potential is limitless!
I agree with Matt… Lifelong habits to acquire and practice are saving, whether for retirement or next year’s vacation, reducing expenses, and managing debt.
Do all three..
In addition to employer-match, save a pre-determined amount – all the time.
To pay off debt, adjust lifestyle to reduce expenses and use that to pay off debt by paying more than minimums in an orderly way.
John L
I think that many of us don’t like to think about adjusting our lifestyles in order to get out of debt. A little bit of sacrifice will go a long way!
Great article! There is no an easy answer to your question: whether to pay off our debt or save for retirement.
Personally, I think we should keep making our retirement contributions no matter what. Unfortunately we all like spending money – it’s our nature. If we pay off our debt, tomorrow we will find something else to spend our money on: new car, a bigger house, vacation – you name it. If we keep making contributions, we are stuck with being frugal, because we don’t have too much money to play with.
I think this is a better approach for a long run to keep building wealth and retire without relying on social security. Thanks for a great article – it makes us think!
It’s a great feeling to be debt free! Not only do you sleep better, work comes with less pressure. If we’re slow at work and I don’t get my full hours i don’t have to panic about how I’ll manage that week. I just enjoy a little down time. It gives me flexibility too, I’m not always looking for the absolute highest paying job.
The rule of thumb should always be pay yourself first, with matching and my contributions to my 401(k) there is 15% of my salary going to my retirement with only a 10% hit, it also makes it possible to contribute to IRAs (both variants) without penalty or phaseout. Make other alterations in your lifespace to eliminate debt, purchase better, less expensive vehicles keep them longer, eat away less frequently. Examine your vacation and travel requirements.
I am thinking about withdrawing from my personal IRA at 59 1/2 to eliminate all my credit card debt (around $6100) Is that a good idea? I also have a Simple IRA that my company contributes to and I match the maximum amount they will contribute.