Pay off debts or save?
“Successful people keep moving. They make mistakes, but they don’t give up. “ ~ Conrad Hilton, founder of the Hilton Hotels chain (1887-1979)
question: I have a dilemma. Should I pay off debts or save for retirement?
reply: Usually we are taught to pay off debts. However, there are a number of reasons why you can be torn between paying off debt and saving for retirement. Either of these can lead to a more confident future, so that there is no right answer for everyone or every situation. Here are some factors to consider when making your decision.
INVESTMENT RATE RETURN VERSUS INTEREST ON DEBT
First, determine the after-tax return on your investments and compare that to the rate you are paying on the debt. For example, eliminating a $ 10,000 credit card balance at 18% is likely a good choice since you will effectively need to get an 18% return on your investments to even get out. This is a major challenge even for professional investors. Note that investment returns are far from guaranteed. In general, the higher the return, the greater the risk. If you invest instead of paying off debts and your investments are causing losses, you may still have to pay debts, but you have not made any profit. In contrast, the rate of return that comes from eliminating high-yield debt is a win.
When analyzing the tradeoffs for an employer-sponsored retirement account, matching an employer can make the decision easier. If your employer matches part of your contributions to the retirement account, it can make it difficult to choose between debt and savings. Let’s say your company equals 50% of your contributions up to 6% of your salary. This means that you will earn a 50% return on that part of your contributions to the retirement account. When breaking an 18% return on debt repayment is challenging, getting a 50% return on your money just by investing is even harder. The old adage about One bird in hand is worth two in the bush applies here. For example, suppose you meet the requirements of your plan and your company meets its plan obligations. You know in advance how much your stake in return will be. Very few systems can offer the same level of security. Because of this, many finance professionals argue that saving at least enough to attract an employer to your contributions may make more sense than focusing on debt.
And don’t forget the tax benefits of contributions to a workplace savings plan. By adding pre-tax dollars to your Plan Account, you move taxes between 10% and 39.6% depending on the federal tax rate. You can use money that is normally used for taxes right away.
It’s not all or nothing
The nature of the debt can influence your decision. For example, when you include deductions, the interest you pay on a mortgage can usually be deducted on your federal tax return. For example, let’s say you pay 6% on your mortgage and 18% on your credit card debt, and your employer equals 50% of your contributions to the retirement account. You might consider devoting some of your available resources to paying off credit card debt and some to your retirement account in order to be in full compliance with the company and continue to pay the tax-deductible mortgage interest.
There’s another good reason to look for ways to accomplish both goals at the same time. Time is your best ally when saving for retirement. If you say to yourself, “I will start saving until my debts are paid in full,” you run the risk of never reaching that point as your good intentions to pay off your debts may wear off at some point. If you postpone saving, it will also decrease the number of years you will have to save for retirement. It might also be easier to achieve both goals if you can cut your interest payments by Refinance this debt and consolidate multiple credit card payments by transferring them to a new credit card or debt consolidation loan at a lower interest rate. Remember, even if your focus is on retirement savings, you should make sure that you can make at least the minimum monthly payments on your debt. Failure to meet these minimum payments can lead to penalties and increased interest rates. These will only make your debt situation worse.
When deciding whether to pay off debt or save for retirement, consider the following factors:
- With retirement contributions automatically deducted from your paycheck, the temptation to spend that money on things that could worsen your debt dilemma is eliminated. If you choose to prioritize debt settlement, make sure that you have a mechanism in place that will automatically direct the money towards the debt – ex. B. by automatically withdrawing funds from your checking account – so that you are not tempted to skip or reduce payments.
- Do you have an emergency fund or other resource to use if you lose your job or have a medical emergency? Remember that if your savings plan for the workplace allows for credit, contributing to the plan means not only that you will contribute to a safer retirement, but also savings that could potentially be used as a last resort in an emergency. Some employer-sponsored retirement plans also allow hardship withdrawals in certain situations – for example, payments required to prevent an eviction or foreclosure of your primary residence – when you have no other resources available. (Remember, however, that the amount of a hardship withdrawal becomes taxable income. If you are not at least 59.5 years old, you may also owe a 10% early distribution tax on that money.)
- If you need to borrow from your plan, make sure you compare the cost of using that money to other funding options, such as: B. Loans from banks, credit unions, friends or family. Although loan interest rates can be cheap, there is a limit to the amount you can borrow, and you generally have to repay the loan within five years. In addition, some plans require that you repay the loan immediately when you leave your job. Your retirement income will also suffer as funds are removed from a deferred tax investment.
- If your focus is on retirement planning rather than paying off debts, make sure you are invested so your returns exceed the interest you owe on that debt. While your investments should be reasonable for your risk tolerance, the return may not be high enough to offset the interest rate you keep paying if you invest too conservatively.
Regardless of your choice, perhaps the most important decision you can make is to take action and get started right away. The sooner you decide on a plan for both your debt and your retirement needs, the sooner you will make progress towards both of these goals. Focus and plan accordingly.
The opinions expressed are those of the writer as of May 17, 2021 but not necessarily those of Raymond James and Associates and are subject to change at any time. The information contained in this report is obtained from sources believed to be reliable, but the accuracy of which cannot be guaranteed. Before making an investment decision, please consult your financial advisor about your individual situation. Past performance does not guarantee future results. Every investment involves risk, including the potential for loss of capital, and there can be no guarantee that any investment strategy will be successful. The information is provided for informational purposes only and is not intended to be a complete description or recommendation. The examples used are hypothetical. A blocking period may apply to contributions from your employer. Please contact your financial advisor for more information. Raymond James and his advisors do not provide tax advice. You should discuss all tax matters with the appropriate professional.
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This article was written by Darcie Guerin, CFP®, First Vice President, Investments & Branch Manager of Raymond James & Associates, Inc., a member of the New York Stock Exchange / SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145, available reached at (239) 389-1041, email [email protected] Website: www.raymondjames.com/Darcie.