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Pay it Down, Or Save it Up?

paying down debt

The question is asked of us all the time…should I focus on paying down my debt or saving up for my retirement?

Both are important to your financial health, but it may not be an “either, or” scenario. The critical thing to do is to get started. Let’s take a look.

Rate of Return vs. Interest Rate

If you pay off a credit card balance, you are essentially saving that interest rate each month. Thus, if your credit card interest rate is 16%, you will be saving that percentage of the balance each month when you pay off the balance. On the other hand, if you invested that money instead, you may not make an after-tax return of greater than 16%. Most likely, you would not get that kind of interest, and even if you did, it’s not guaranteed and fraught with risk. The return generated by eliminating high-interest debt is a sure thing.

Workplace Retirement Accounts

If you have a retirement account in which your employer matches 50% of your contributions, you earn a 50% return on that money up to a certain percentage of your salary. Not only are you deferring taxes until retirement, but there are few, if any, investing opportunities that provide the certainty of getting a 50% return on your hard-earned dollars.

Most financial experts agree that saving enough in your retirement account to qualify for your employer’s matching contributions makes a lot of sense. It’s free money.

It’s Not “All or Nothing”

Sometimes the decision to save for retirement versus paying off debt will be affected by the kind of debt you have.

For example, your mortgage debt interest is generally deductible on your federal tax return, and it’s probably lower than the interest rate on your other loans or consumer debt. You may want to continue paying it as usual while directing some of your resources to pay off your high-interest credit card debt and continuing contributions to your retirement account.

Time is your friend when saving for retirement. Don’t wait to start saving until your debts are paid off. You will run the risk of never getting debt-free, and you will reduce the number of years you have to save for retirement.

Keep in mind, you could kill two birds with one stone by refinancing significant consumer debt. You may be able to consolidate several credit card payments by rolling them into a new card or debt consolidation loan with a lower interest rate.

If you are focused on reinforcing your retirement savings, make sure that you can comfortably make the minimum monthly payments on your debt. Failure to make the payments will result in penalties and increased interest rates—it will completely undo what you’re trying to accomplish!

Other Considerations

Here are some other factors to think about.

  • Have your retirement plan contributions automatically deducted from your paycheck. You don’t miss what you don’t have! It will save you the temptation of “dipping in” to funds that are intended to go into your retirement plan.
  • The same goes for paying down debt. Put a mechanism in place that will automatically direct funds toward the debt so that you won’t be tempted to skip or reduce payments.
  • Establish an emergency fund for the bad news moments like losing a job or having a medical issue. If your workplace savings plan allows loans, they can potentially be used in an emergency or hardship situation as well. Just remember that the amount of any hardship withdrawal becomes taxable income, and if you aren’t at least age 59 1/2, you also may owe a 10% premature distribution tax on that money.
  • If you borrow money from your plan, compare that cost to financing with other options first. Some plan restrictions may include limited borrow amounts, and generally, you must repay in five years. Also, be advised that some plans require you to repay the loan immediately if you leave your job. Your retirement earnings will also suffer as a result of removing funds from a tax-deferred investment.
  • Make sure your investments have a chance of exceeding the interest you have to pay on your debt. While your investments should be appropriate for your risk tolerance, if you invest too conservatively, the rate of return may not be high enough to offset the interest rate you are paying.

Take action and get started now. The sooner you decide on a plan for both your debt and your need for retirement savings, the sooner you’ll begin to make progress toward achieving both goals.

Call C&B Accounting for advisement on your particular situation.

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