It’s a catch-22: You feel that you should focus on paying down debt, but you also want to save for retirement. It may be comforting to know you’re not alone.
According to an Employee Benefit Research Institute survey, 18 percent of today’s workers describe their debt level as a major problem, while 41 percent say it’s a minor problem. And workers who say that debt is a problem are more likely to feel stressed about their retirement savings prospects.
Perhaps it’s no surprise then that the largest proportion (21 percent) of those who take a loan from their employer-sponsored retirement plan do so to pay off debt.
But borrowing from your plan can have negative consequences on your retirement preparedness down the road. Loan limits and other restrictions generally apply as well.
The key to managing debt repayment and retirement savings simultaneously is to understand a few basic financial concepts that will help you develop a strategy for both.
Compare the potential rate of return with the interest rate
on your debt
Probably the most common way to decide whether to pay off debt or to make investments is to consider whether you could earn a higher rate of return (after accounting for taxes) on your investments than the interest rate you pay on the debt. For example, say you have a credit card with a $10,000 balance that carries an interest rate of 18 percent. By paying off that balance, you’re effectively getting an 18-percent return on your money. That means your investments would generally need to earn a consistent, after-tax return greater than 18 percent to make saving for retirement preferable to paying off that debt. That’s a tall order for even the savviest professional investors.
Also, bear in mind that all investing involves risk; 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.
of an employer match
If you have an opportunity to save for retirement via an employer-sponsored plan that matches a portion of your contributions, the debt-versus-savings decision can become even more complicated.
Let’s say your company matches 50 percent of your contributions up to 6 percent of your salary. This means you’re essentially earning a 50-percent return on that portion of your retirement account contributions, so it might make sense to save at least enough to get any employer match before focusing on debt.
And don’t forget the potential tax benefits of retirement plan contributions. If you contribute pretax dollars to your plan account, you’re immediately deferring anywhere from 10 percent to 39.6 percent in taxes, depending on your federal tax rate. If you’re making after-tax Roth contributions, you’re creating a source of tax-free retirement income.
Consider the types
of debt you have
Your decision may also be influenced by the type of debt you have. For example, if you itemize deductions on your federal tax return, the interest you pay on a mortgage is generally deductible — so even if you could pay off your mortgage, you might not want to do so.
Let’s say you’re paying 6 percent on your mortgage and 18 percent on your credit card debt, and your employer matches 50 percent of your retirement account contributions. You might consider directing some of your available resources to paying off the credit card debt and some toward your retirement account in order to get the full company match, while continuing to pay the mortgage to receive the tax deduction for the interest.
There’s another good reason to explore ways to address both debt repayment and retirement savings at once. Time is your best ally 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. Postponing saving also reduces the number of years you have to save for retirement.
It might also be easier to address both goals if you can cut your interest payments by refinancing 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 minimum monthly payments on your debt. Failure to do so can result in penalties and increased interest rates, which would defeat the overall purpose of your debt repayment/retirement savings strategy.
BARBARA KENERSON is first vice president/Investments at Janney Montgomery Scott LLC and can be reached at BarbaraKenerson.com.