Managing Debt While Saving for Retirement

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% of today’s workers describe their debt level as a major problem, while 41% say it’s a minor problem. And workers who say that debt is a problem are also more likely to feel stressed about their retirement savings prospects.1 Perhaps it’s no surprise, then, that the largest proportion (21%) of those who have taken a loan from their employer-sponsored retirement plans have done so to pay off debt.2 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 in managing both debt repayment and retirement savings is to understand a few basic financial concepts that will help you develop a strategy to tackle both.

Compare potential rate of return with interest rate on 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%. By paying off that balance, you’re effectively getting an 18% return on your money. That means your investments would generally need to earn a consistent, after-tax return greater than 18% to make saving for retirement preferable to paying off that debt. That’s a tall order for even the most savvy professional investors.

And 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.

Are you eligible for an employer match?

If you have the 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% of your contributions up to 6% of your salary. This means you’re essentially earning a 50% return on that portion of your retirement account contributions. That’s why it may 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 pre-tax dollars to your plan account, you’re immediately deferring anywhere from 10% to 39.6% 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.3

Consider the types of debt

Your decision can 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 may not want to. 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, while continuing to pay the mortgage to receive the tax deduction for the interest.

Other considerations

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 left 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.

1Employee Benefit Research Institute, 2017 Retirement Confidence Survey

2Employee Benefit Research Institute, 2016 Retirement Confidence Survey

3Distributions from pre-tax accounts will be taxed at ordinary income tax rates. Early distributions from pre-tax accounts and nonqualified distributions of earnings from Roth accounts will be subject to ordinary income taxes and a 10% penalty tax, unless an exception applies. Employer contributions will always be placed in a pre-tax account, regardless of whether they match pre-tax or Roth employee contributions.

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