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Debt vs. Retirement: How Much To Put Toward Each

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Recently, a good friend asked me a seemingly simple question: “Laura, does it make sense to save for retirement while also carrying debt?”

The answer, however, is anything but simple and depends on a number of different factors.

“A lot of people are trying to figure out, how do I balance multiple goals? And a lot of times, that’s a combination of paying down debt, building up savings and starting to save or getting on track to save for retirement,” says Sophia Bera, a certified financial planner and founder of Gen Y Planning, adding that she likes to call retirement “financial independence,” which not only doesn’t sound far off but also can come at whatever age you choose.

The right balance between debt payments and savings contributions isn’t simply a matter of making a mathematical calculation. “It comes down to the different financial goals you have and what you have going on in your current situation,” says Bera.

Most importantly, don’t become paralyzed by the amount you owe or the complexity of the question. Instead, formulate as good a plan as you can, and automate it.

“That’s really how you increase your net worth,” Bera says. Last summer, she had some clients, a couple with student loan debt, automate some of their financial behaviors. Between July and January, they had a baby, the wife took eight weeks of maternity leave at 60% of her salary, and then returned to work at just four days a week — and yet, their net worth increased $18,000 during those six months despite the added baby expenses and lower income.

“The reason is they are putting automatic payments toward their student loans, and emergency savings, and they’re each contributing 10% of their income to their 401(k)s at work,” says Bera, who just came out with an ebook, “What You Should Have Learned About Money, But Never Did.”

Here’s how to decide whether to pay down debt and save for retirement simultaneously, and if so, how much to allocate toward each.

1. Take stock of what you have and what you owe.

Getting a snapshot of your net worth will show you the current balance between savings and debt right now, and you’ll be able to measure your progress by it. Don’t feel overwhelmed by whatever number you see — it’s just one point in what will be the long journey of your financial life, and remember that with the right habits, that number will have moved in a positive direction in just six months.

2. Find out the interest rates on all your debts.

Write these down in a spreadsheet from highest interest rate to lowest interest rate. Include everything from credit cards to car loans to your mortgage to student loans. This list will be helpful when trying to prioritize your debt payments against the potential growth of your retirement contributions.

3. See if you can refinance any of your loans.

Car loans and mortgages have low interest rates now, so you might want look at refinancing. Bera has a number of clients refinancing for lower rates, or to 15-year mortgages. “When [one couple] took out a 30-year mortgage five years ago, it was at 5%, and now they’re able to refinance for 3.5% but on a 15-year mortgage and their payment is only going up $100-$200 more a month,” she says.

4. Create a workable budget and settle on the amount that will go toward financial priorities.

In order to make your plan to pay down debt work, you need to make sure your budget is 100% achievable and that you won’t overspend. If you’re not sure whether you’re living within your means, revisit your budget now — or, if you have an irregular income or freelance, review these budget guidelines.

When creating your budget, determine how much money you can allocate toward financial priorities like debt, savings and retirement. If you can set aside at least 20% for those goals (excluding whatever you put into your 401(k) pre-tax), then you can make progress at a good pace.

5. Decide whether you need to stop using your credit cards.

If your debt is due to overspending, and you’re still not sure whether you have control over your budget, take your cards out of your wallet and use a weekly allowance in cash. Also, cancel automatic charges on your cards, like gym memberships, and then call the credit card company and ask them to lower your interest rate or transfer balances to take advantage of 0% interest offers.

If you feel like you can use credit responsibly, give yourself a weekly allowance that fits with your budget and stick to spending that number each week. (You can use an Excel spreadsheet or a service like Mint to track your spending.)

6. Set aside at least one month’s worth net pay for emergencies. 

At minimum, you want one month’s worth of savings for emergencies. So, if your net monthly pay is $3,000, have that amount in an emergency fund before aggressively paying down debt. If you don’t currently have it, pay the minimums on your debt until you amass your emergency savings, and then start aggressively paying down your debt.

When you have debt, it may seem silly to keep money locked away in a savings account, but doing so “stops the credit card cycle,” says Bera. “A lot of times, people are living paycheck to paycheck and don’t take time to build their emergency savings, and something goes wrong, like a car repair, and $500 goes on their credit card — and they’re being charged interest every month.”

7. As long as you can afford it, get your full employer 401(k) or 403(b) match.

If you know that you can set enough money to pay at least the minimums on your debt every month (and preferably more) plus spare some for retirement, then do what it takes to get your company retirement match. It’s important to make room in your budget to get this match because it’s an immediate 100% return on your investment (or 50% or some other percentage, depending on your company’s match rules), and you will rarely see that kind of return on any investment you make. So, even if you have debt, it’s worth it to divert dollars you could put toward your debt into your 401(k) — plus, you’ll get a tax break for it.

8. If you can’t afford to set aside money to obtain the company match, cut expenses or earn more money to do so. 

“The people that make the biggest changes in their financial situation are those that increase their income quickly but continue to lead a pretty modest lifestyle,” says Bera. “If they earn $500 or $1,000 more in freelance work a month, but can only trim their budget only $200, then suddenly you go from being able to put $200 a month toward your financial priorities to being able to put $1,200 a month toward them — and that’s when people make a lot of progress.”

9. Now figure out how much you can pay toward your debt.

Add up the minimums on your debt repayments and subtract that from the amount you can devote to financial priorities.

Depending on your personal situation, you will either put 100% of the leftover toward your highest-interest-rate debt, or you will allocate a portion of it there and the rest toward retirement. How much to put toward each depends on a number of factors, including your time horizon for retirement and the interest rates on your debt.

While this question is best put to a financial planner who can look at your entire financial picture, one way to think of it is that, if your student loan interest rate is 6.8%, the payments you make toward those loans give you a guaranteed 6.8% return on your money. Your retirement investments, especially after accounting for inflation, may not do as well. On the other hand, if you’re 50 and are behind on saving for retirement, you’ll still want to get the ball rolling since time is the biggest factor in how much your investments can grow.

Bera says that for any debts with interest rates above 6%, she favors paying down debt over saving for retirement, but once you eliminate all those and are left with debts with lower interest rates, the emphasis would swing back to retirement.

10. If you can, save for retirement in a Roth IRA or increase your 401(k) contributions.

If you have extra money you can put toward retirement, even while aggressively paying down debt, it would be good idea to contribute to retirement in a Roth IRA. This type of retirement account comes with huge tax benefits: While you’ll pay taxes on the contribution now, you won’t pay any on the earnings, which could be substantial, especially if you’re far from retirement.

If you’re the kind of person whose financial philosophy is inertia, then skip the hassle of opening up a Roth IRA on your own, setting up transfers and choosing the investments. Just these steps alone will keep a certain segment of the population from doing anything at all. If that’s you, then just increase your 401(k) contributions above the minimum needed for the company match, and set them to increase by 1% every six months or a year, or by the percentage of whatever raises you receive.

If you’re a high earner whose income puts you above the limits for a Roth IRA, then after getting your company match, max out your 401(k). If you still have money you can put away for retirement after that, then you can either go with a non-deductible IRA, or you could opt for a taxable account, which give you flexibility in using that money.

 “You can use that brokerage account money for anything — to pay for your kids’ college, to create financial independence earlier,” says Bera. “I’ve seen people retire at 55 instead of 66. You can’t tap your retirement account until you’re 59 1/2, but there’s no penalty for tapping your brokerage account. You just have to pay capital gains tax.”

If you decide you need a planner …

As is true of any sticky financial question, sometimes it’s best to have a professional look at your entire financial picture to help you see how best to allocate your money. (Here’s why financial plans aren’t only for the 1%.)

If you think it might make sense for you, you can search for a planner on the XY Planning Network, the National Association of Personal Financial Advisors or the Financial Planning Association to find a fee-only financial planner who won’t be selling you financial products but will instead give you the best advice for your personal situation. (Read here to understand why it’s so important to find a fee-only financial planner.)

And check out this slide show to see what questions you should ask a potential financial advisor.

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