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If you have cash remaining after covering your monthly expenses, how should you use it? Do you pay down nagging debts, or pour all the money into your retirement savings? There's no perfect answer, as it's a largely personal decision.
The debt-versus-retirement debate requires a survey of your total debts and their interest rates, types of retirement plans available to you, and how much longer you have to save. Examining your emotional relationship with money is also key to the process.
Everyone's circumstances vary, so the answer depends on you. Once you evaluate your debt and other factors like time horizon, risk tolerance, and rates of return, you can make an informed decision. Fortunately, many can find a balance between the two goals.
When in debt, your first priority should always be to pay at least the minimum on each of your accounts. You don't want to incur added fees and penalties for not doing so. The question here is what to do beyond the minimum on debt. Once you've met the minimum obligation, decide whether to emphasize saving or focus on debt.
These are three scenarios under which you should prioritize debt payoff:
Your debt interest rates play a critical role in how you manage your money. If you have student loans at a fairly low interest rate (and are getting a tax deduction on interest paid), taking longer to pay them off isn't going to hurt your bottom line much.
However, high-interest debt is something you want to knock out rapidly. For example, credit card interest rates averaged 14.6% in 2021, according to the Federal Reserve, and plenty of companies charged more than that.
The Securities and Exchange Commission points out: "No investment strategy pays off as well as, or with less risk than, eliminating high interest debt." In other words, you're unlikely to beat those double-digit rates of return with a 401(k).
Matt Goren, director of the CFP® certification education program and an assistant professor of financial planning at the American College of Financial Services, echoes this. "Paying off debt is like getting a guaranteed return on investment," he says.
It's worthwhile to pay these debts off even if it means delaying retirement savings a bit. Marigny deMauriac, a CFP® professional and accredited asset management specialist, encourages people to pay down debts with double-digit interest rates first. "Not all debt is the same, so don't treat it like it is," deMauriac says.
If you have a plan to pay all your debt off within about two years or less, chances are putting off serious retirement savings until you do so won't have a significant impact on the amount available in your retirement fund when you're finished working.
Some who propose aggressive debt payoff plans believe it's detrimental to try doing too many things at once. While you can't completely ignore everything but debt, it is possible to be laser-focused on getting out of debt for a relatively short period of time.
Once your debts are completely paid off — and typically that means non-mortgage debt, though some include that too — you can focus on retirement. Funneling all extra cash toward debt, rather than dividing it over multiple categories, will complete your debt payoff journey more quickly. That way, when you shift focus to retirement and other goals, you're no longer preoccupied with debt and will be able to invest more for the future.
Remember the psychological aspects of this decision. For many people, debt is a tremendous burden that they can't get rid of fast enough. Perhaps you have certain emotions attached to your debt that make it difficult to move forward.
"Some people hate the idea of being in debt and would feel a lot better if they were debt free," Goren says. "Even if it's not technically the most efficient thing to do, those people may be better off prioritizing debt."
If debt is overwhelming, that's a good reason for paying off debt before shifting to focus on retirement accounts. It still depends on the total and type of debt, interest rates, and your time horizon. But when your debt is causing you undue stress, paying it off more rapidly can free you to focus on other goals more effectively.
Focusing on retirement instead of debt repayment is usually wise if your debt is low-interest and if your employer offers a 401(k) match. Plus, there are tax advantages to retirement plans, and the longer your money has to compound before you retire, the better.
Consider putting most of your extra cash toward retirement under these circumstances:
Most financial advisors will tell you that regardless of how much debt you may have, you shouldn't miss out on a 401(k) match. Robert Johnson, a chartered financial analyst (CFA) and professor at Creighton University, equates non-participation in a company 401(k) match to "turning down free money."
If your employer offers matching on your retirement contributions, it's pretty hard to turn that down. Say your company matches your 401(k) or 403(b) contributions up to 3%. By contributing up to the maximum match, you gain added contributions as well as tax benefits in the short term.
Tax advantages from a 401(k) mean that it's wise to contribute even without a company match, though the match sweetens the deal. "New graduates should do whatever it takes to participate in their company's 401(k) plan to the level to get the full employer match," Johnson advises.
If you select a Roth 401(k) rather than a traditional, you still get some tax benefits. Instead of a reduction on your taxable income today, you can make withdrawals tax-free if you meet all of the program requirements.
When your creditors charge relatively low interest rates, focusing on investing towards retirement might be the better option. Of course, you should continue to pay the minimums. But if your loans have reasonable rates, the return on your retirement investments are likely to exceed the additional interest charges incurred on the debt.
"If a debt's interest rate is lower than about 5%, you're probably better off in the long run focusing on savings," Goren says.
While nobody can perfectly predict the rate of growth of their investments, you can make reasonable estimates to determine whether investing is better than paying off debt. The lower the debt interest rate, the more likely your 401(k) returns will beat it.
If you can't pay off your debt in two years or less, it may be preferable to start and continue saving for retirement. The problem is that the longer your debt payoff takes, the more you cut into your potential for retirement savings to grow.
"One of the biggest mistakes people make when repaying student loans is placing too high a priority on the repayment," Johnson cautions. He suggests redistributing your priorities, as paying off loans is laudable but shouldn't prevent you from contributing to your retirement.
One of the cornerstones of investing for retirement is time. The younger you are when you begin saving in retirement accounts, the longer your savings can make favorable returns. Delaying retirement contributions too long means you'll have to play catch-up, so more than two years for debt repayment isn't a good idea.
While this comes with a giant asterisk, some people should consider the possibility of debt forgiveness. For example, if you're involved in a student loan forgiveness plan such as Public Service Loan Forgiveness, follow that program's requirements rather than paying extra on those loans.
If there's any chance part of your debts could be wiped out through loan forgiveness or cancellation, focus on retirement until forgiveness is official. However, beware that securing loan forgiveness isn't always a smooth path. You'll need to be prepared in case you're still obligated to pay the debt.
Let's not forget the third option: splitting the difference. The issue of debt payoff versus retirement doesn't have to be an either/or proposition.
"If you are like most people, you need to balance debt paydown and retirement savings," deMauriac says.
Many people can tackle both debt and retirement goals at the same time. Focusing on retirement even while paying down debt is acknowledging that in addition to becoming debt-free, you want long-term financial security.
First of all, you should always pay the minimum on each debt balance to avoid losing assets or incurring large penalties. After that, you may wish to design your own plan that involves both debt payoff and retirement savings concurrently.
One of these approaches may fit:
In each of these situations, you would gradually shift the balance of how you prioritize your goals. As debts decrease, add more to retirement. It's impossible to provide a one-size-fits-all answer, given the wide variations in financial circumstances and emotional responses to debt.
