Pay off Debt or Save for Retirement
By Elaine E. Bedel, CFP®
Course Section
- Overview
- Keys to Success
- Where to Save
- Inheritance Tips
- Split the Tax Refund
- Pay off Debt or Save for Retirement
You have some extra money. Should you use that money to pay down debt or to save for retirement? Or if money is really tight, should you cut back on how much you are contributing to your 401(k) to pay down your loans and credit cards? Financial planners are frequently asked whether it is better to work on paying off debt or make contributions to a retirement account. The answer requires balancing a number of factors and understanding some trade offs.
Contribute to Your 40l(k)
There are some obvious advantages to contributing to your 401(k). You can
reduce your income taxes since the dollars you put into your account are not
taxed. You are getting free money to build your retirement account when what
you add to your 401(k) is matched by your employer. Also the investment income
your account earns is tax deferred, further reducing what you have to pay in
taxes now. Thanks to the power of compounding, the more money and the more
years you have funds in the 401(k), the more money you will have for
retirement. So contributing in the early years of your career and increasing
the amount you are saving can really pay off big.
Reduce Your Debt
The decision to pay off debt instead of contributing to your 401(k) depends on
the type of debt and how paying down that debt affects your cash flow. If the
debt is a mortgage or a car loan, make your payments as scheduled. Do not
forfeit your 401(k) contributions to accelerate payoff of these loans.
If you have significant credit card debt with high interest rates, your decision may be different. It will take approximately twenty years to pay off your credit card debt if each month you pay only the minimum required by the credit card company. A better idea is to determine the amount that you can afford to pay from your cash flow and pay that amount each month. For example, let's assume that your current credit card balance is $10,000 with an annual interest rate of 18%. If you pay $400 each month, it will take 32 months to get to a zero balance. Your total payments would be $12,628. This is $2,628 of interest in addition to the original $10,000 that you charged. If you can increase your payment to $600 each month, you can pay off the credit card in 20 months (one year faster) and pay less than $1,600 in interest. This strategy saves you more than $1,000 in interest payments and frees up money that you could put in your 401(k). The faster you can pay off the credit card debt, the less it will cost you.
What to do? If you have no other means for paying off or systematically reducing your credit card debt, you should allocate all extra funds, including your 401(k) contribution, to get rid of this debt. Once your have your credit card balance under control, you should restart your 401(k) savings. You will need to control your spending and credit card use so you don't accumulate debt on your credit card again.
Managing your cash flow so you can make your debt payments as well as contribute to your 401(k) is key to achieving financial security for your retirement years.
AARP Resources
Allocating Your Money to Meet Your Goals
Understand how to pick investment strategies that will help you meet your
goals.
Saving:
The Keys to Success
Learn more about how compounding works for you as a saver and against you as a
borrower.
Do You
Have Too Much Debt?
Tips on ways to reduce your debt.
Elaine Bedel, CFP®, is a personal financial planner with over 25 years of providing financial planning and investment management for executives, professionals, and entrepreneurs. She is the President and Owner of Bedel Financial Consulting and has served as Chair of both the Financial Planning Standards Board and Certified Financial Planner Board of Standards.
