Like many people, you may be torn between paying off debt and the need to save for retirement. Both are important; both can help give you a more secure future. If you're not sure you can afford to tackle both at the same time, which should you choose?
At Portfolio Solutions®, we believe there's no one-size-fits-all strategy for debt reduction and retirement savings. When developing your approach, here are some factors you can consider:
Rate of investment return versus interest rate on debt
A popular 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 on your investments than the after-tax interest rate on your debt. For example, if you have a credit card on which you pay 18% nondeductible interest, you're effectively getting an 18% return on your money by getting rid of those interest payments.
For investing to be more effective in this scenario, you'd need to generate a return greater than 18%--a tough challenge for any investor. It's also important to keep in mind that investment returns are not guaranteed, carry risk, and can result in loss of principal. By contrast, the return from eliminating high interest debt is a sure thing.
Employer's match may change the equation
If your employer matches a portion of your workplace retirement account contributions, investing may become a more appealing option. Let's say your company matches 50% of your contributions of up to 5% of your salary. That means you're earning a 50% tax free return on that portion of your retirement account contributions. Few investment options offer that level of return, never mind with 100% certainty. Additionally, you have the added benefit of compound interest—making sure your money is working for you for the maximum amount of time possible. 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.
There are also tax benefits to contributing to a workplace retirement plan. By contributing pretax dollars to your plan account, you're deferring anywhere from 10% to 37% in taxes, depending on your federal tax rate. You're able to put money that would ordinarily go toward taxes to work immediately.
Combine approaches into a single strategy
Oftentimes, a split approach is the most effective. Let's say you're paying 6% on your mortgage and 18% on your credit card debt, and your employer matches 50% of your retirement account contributions. You might consider dedicating some resources to your workplace retirement account to generate the 50% returns, continue to pay the tax-deductible mortgage interest, and then allocate the rest of your resources towards chipping away at your credit card debt. By understanding all your debt and investment options you can commit your resources in a way that is optimal for you.
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 that has 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; those will only make your debt situation worse.
Take action now
Regardless of the strategy you select to balance saving for retirement with paying off debt, at Liberty Wealth Advisors® we believe the most important thing you can do is take action and get started now. The sooner you begin to execute on your plan, the sooner you'll start to make progress toward achieving both goals.
Please contact your Liberty Wealth Advisors® Financial Advisor with any questions by calling (248) 689-1550. Not a current client, but ready to get started? Click here to schedule a phone consultation to learn more about Liberty Wealth Advisors® and how we can serve you!
All information presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service, nor should it be construed as tax or legal advice. Please click here to see our blog disclosure, which immediately follows the "Applicable Law and Venue" section.