Pay Down Debt or Save?

“Successful people keep moving. They make mistakes, but they don’t quit.”~ Conrad Hilton, founder of the Hilton Hotels chain (1887-1979)

Question: I have a dilemma. Should I pay down debt or save for retirement?

Answer: Typically, we are taught to pay down debt, yet there are a number of reasons why you may be torn between paying off debt and the need to save for retirement. Both may lead to a more confident future so there’s no one right answer for everyone or every situation. Here are a few factors to consider when making your decision.

RATE OF INVESTMENT RETURN VERSUS INTEREST RATE ON DEBT 

Start by determining the after-tax rate of return on your investments and compare this to the rate you’re paying on the debt. For instance, eliminating a credit card balance of $10,000 at 18% is likely a good choice as you’d need to effectively get an 18% return on your investments to come out even. That’s a tough challenge even for professional investors. Keep in mind that 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 win. 

When analyzing the trade-offs for an employer sponsored retirement account, an employer’s match may make the decision easier. If your employer matches a portion of your workplace retirement account contributions, this can make the debt versus savings decision more difficult. Let’s say your company matches 50% of your contributions up to 6% of your salary. That means that you’re earning a 50% return on that portion of your retirement account contributions. If surpassing an 18% return from paying off debt is a challenge, getting a 50% return on your money simply through investing is even tougher. The old saying about a bird in the hand being worth two in the bush applies here. Assuming you conform to your plan’s requirements and your company meets its plan obligations, you know in advance what your return from the match will be; very few investments can offer the same degree of certainty. That’s why many financial professionals argue that saving at least enough to get any employer match for 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 contributing pretax dollars to your plan account, you’re deferring anywhere from 10% to 39.6% in taxes, depending on your federal tax rate. You’re able to put money that would ordinarily go toward taxes to work immediately. 

IT’S NOT ALL OR NOTHING

The type of debt may influence your decision. For example, if you itemize deductions, the interest you pay on a mortgage is generally deductible on your federal tax return. 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 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 and continuing to pay the tax-deductible mortgage interest. 

There’s another good reason to explore ways to simultaneously address both goals. 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 fade at some point. Putting off saving also reduces the number of years you have left to save for retirement. It might also be easier to address both goals if you can cut your interest payments by refinancing that debt and consolidating 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. 

OTHER CONSIDERATIONS

When deciding whether to pay down debt or to save for retirement, make sure you take into account the following factors:

• Having retirement plan contributions automatically deducted from your paycheck eliminates the temptation to spend that money on things that might make your debt dilemma even worse. If you decide to prioritize paying down debt, make sure you put in place a mechanism that automatically directs money toward the debt – for example, having money deducted automatically from your checking account – so you won’t be tempted to skip or reduce payments.
• Do you have an emergency fund or other resources that you can tap in case you lose your job or have a medical emergency? Remember that if your workplace savings plan allows loans, contributing to the plan not only means you’re helping to provide for a more confident retirement but also building 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 necessary to prevent an eviction from or foreclosure of your principal residence – if you have no other resources to tap. (However, remember that the amount of any hardship withdrawal becomes taxable income, and if you aren’t at least age 59 and a half, you also may owe a 10% premature distribution tax on that money.)
• If you do need to borrow from your plan, make sure you compare the cost of using that money with other financing options, such as loans from banks, credit unions, friends, or family. Although interest rates on plan loans may be favorable, the amount you can borrow is limited, and you generally must repay the loan within five years. In addition, 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.
• If you focus on retirement savings rather than paying down debt, make sure you’re invested so that your return has a chance of exceeding the interest you owe on that 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’ll continue to pay.

Regardless of your choice, perhaps the most important decision you can make is to 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 start to make progress toward achieving both goals. Stay focused 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 subject to change at any time. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Past performance does not guarantee future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. The information is being provided for informational purposes only and is not a complete description, nor is it a recommendation. Examples used are hypothetical. Making contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information. Raymond James and its advisors do not offer tax advice. You should discuss any tax matters with the appropriate professional. 

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This article provided by Darcie Guerin, CFP®, First Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at (239)389-1041, email darcie.guerin@raymondjames.com Website: www.raymondjames.com/Darcie.