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Edited to correct mistaken math.
Deep in the bowels of the internet, we personal finance bloggers have a secret hideaway where we gather to hone our craft. In a recent discussion some of us wondered which we ought to prioritize: retirement savings or debt reduction?
This is a question that’s bugged me recently. As I’ve begun to get my finances under control, I’ve found it difficult to prioritize money allocation. Should I continue to pay down my debt? Or should I set some money aside for retirement? In our discussion, Lazy Man pointed to a CNN Money article from last spring: Which “top priority” is really no. 1? Ryan D’Agostino writes:
At my age — at any age, probably — you hear a lot of sentences that begin, “The most important thing to do with your money right now is….” They can’t all really be the most important, but certain moves can pay off more at certain times in your life. The two I’m hearing most about right now are “feed your 401(k)” and “pay off credit cards.”
[...]
I ran some numbers with the help of several financial planners, and I was surprised by the passion on both sides of the answer. In the end, though, the winning move became clear: Pay some money toward the debt and some toward the 401(k).
Actually, according to the article the mathematically smart choice in all scenarios is to pay the credit card first. However the difference in the end was slight: just $200/year over 54 months.
Should you really base this decision on such a paltry sum? Or is getting into the habit of saving the more important consideration? “Usually, when a client comes with this question, I don’t even run the numbers up front,” says Aaron Coates, a financial planner at Compass Wealth Advisors in Elkhart, Ind. and co-founder of NextGen, a group of financial planners 36 and under. “I assess where the person is behaviorally.”
Once again the answer is: do what works for you. What is going to make you happiest in the long run? Do you feel oppressed by debt? Then pay off the credit card before you begin investing. Does your lack of retirement savings make you anxious? Then save a little for retirement while working on the debt. As Mapgirl wrote in our private discussion:
I contribute 15% to my 401k and I also try to pay down my credit cards. Now that I’m settled into a good pattern of life, I am going to try and pay the cards down aggressively. If you can save and pay off the debt at the same time, might as well do both. Yes, people say you ought to pay off your debt first, but I feel better knowing that I am socking some money away too. The debt will get taken care of, but if I don’t start saving, I never will.
[CNN Money: Which "top priority" is really no. 1?]
This article is about Choices, Debt, Retirement Tuesday, 6th February 2007 (by J.D. Roth)
February 6th, 2007 at 5:29 am
We went back and forth with this one. We really want to be debt free (unsecured debt) this year - 2007. But, we also want to max out our 401k. So, what are we doing? We are doing both. We are following Ramsey’s plan (except for the retirement contributions) and we are tracking our expenses, working on a budget, we have put off any purchases that are wants (vs. needs) and we have figured out a way to pay down our debt and contribute to our 401k. We were not comfortable skipping a year on our retirement contributions so we aren’t skipping a year.
February 6th, 2007 at 5:30 am
You missed the numbers. The difference is $680 in the 401(k). The quote is “less than $200 a year”.
Don’t forget the assumptions: a 15% rate on the credit card and only $4000 debt. Any changes on that will make a big difference in interest saved in the end.
But, of course, as the snowball effect shows, personal finance is more about mind than money. But saying that it’s almost the same, seems a bit strange to me.
February 6th, 2007 at 5:49 am
I’m with mapgirl on this one. Fortunately, none of my debt is at a really high interest rate (nothing over 8.75% at the moment). If I did have something in the double digits, I might feel differently.
But, as it is, I got a late start on retirement saving. The idea of delaying it longer and missing more years of the magic of compounding is just too scary.
February 6th, 2007 at 5:53 am
I’ve been wondering this myself. I just graduate from college with about $20,000 in student loans at an average rate of 6%. I’ve been maxing out my employer’s matching contributions to my 401(k), while putting any extra money towards the highest rate debt.
Even if I could earn more on my 401(k), I will certainly feel better not having those loans to pay off. Especially once it’s down to just one lender.
February 6th, 2007 at 6:12 am
Don’t forget the assumptions: a 15% rate on the credit card and only $4000 debt.
Exactly right. I appear to have edited out an important line that was in here for most of the time I was drafting this. I wrote something to the effect that it’s important to run the numbers for *your* situation to see if the difference is significant or not. It’s good advice. *Your* situation may be very different. Good point!
February 6th, 2007 at 6:30 am
Another thing to consider is that not everyone has the same expectations for retirement. I actually like to work and have skills that can be easily transferred to freelancing, so I don’t plan to fully “retire” until/unless I am forced to by illness. My plan has always been to work at least part-time until I die, so I’m not as focused on building a huge retirement nest egg as I might otherwise be. Of course there’s always the risk that I won’t be able (for whatever reasons) to market my skills when I get to retirement age, or that I’ll be tired of working by then, but it’s a risk I’m willing to take. I contribute generously to my retirement accounts, but it’s not my top priority.
February 6th, 2007 at 6:43 am
You have to run the numbers for sure, have the cash flow to pay enough debt to avoid bankruptcy.
If your 401k is 1 for 1 matching you get 100% return of anything you put in it and it is tax free until you retire. Unless you have a loan shark then this is the most valuable use of money if you have the cash flow to pay the requirements on your other debts.
I would also pay less on Student loans and mortgages than consumer debt because these loans have tax benefits, and they actually represent something that should keep its value.
I still haven’t decided if it is generally better to fund a Roth IRA(assuming you have a well funded 401k/403B)or pay down the mortgage. If you pay down a fixed mortgage then you still have the same monthly payments, just fewer months. Roth’s have yearly contribution caps and you can always take out principle payments and use for other things if needed.
February 6th, 2007 at 7:16 am
I’m currently putting 7% toward 401(k), however my company will match 6% for anyone contributing over 2%, which is probably very generous and very rare. I’m debating with my wife over dropping down to that minimum 2% to keep the company 6% match, and using the rest to pay down our non-mortgage debt (less than $1000 on credit card, just under $14000 for student loans combined). She’s against changing the 401(k) contribution, but I frankly don’t see the big deal. I’m 30, I’ve been contributing to 401(k) at both places I’ve worked since I was 22. Dropping down to 2%, at least until things are paid off, and then even putting some into savings in our HSBC Direct account (5.05% APY). That 5% difference is a nice amount to have to work with each month.
What do you guys think?
February 6th, 2007 at 7:20 am
You missed the numbers. The difference is $680 in the 401(k). The quote is “less than $200 a year”.
You’re right. I’ve made a correction to the post.
February 6th, 2007 at 8:30 am
Good grief, that MSN Money article was about the most poorly written thing I’ve read in a long time. The editors actually permitted “blah blah blah”?
This may be a little bit of a tangent, but I’ve got taxes on the brain, and it’s something that I always think about when I read financial projections: the tax impact is always overstated. Whatever “tax bracket” you’re in doesn’t kick in until all the exemptions, deductions, and credits are factored out. At least for married people with a couple of kids–not an uncommon situation–that’s a pretty big chunk and the overall percentage of income due as federal income tax is way smaller than any stated “bracket percentage”.
My family’s in this situation (two earners, two kids) and I just peeked at our taxes for 2005 and 2006. Total income 2005 $56K, total taxes $2K, percentage 3.5%. Total income 2006 $61K, total taxes $2.1K, percentage 3.4%.
I recognize that the percentages can be way different for people who are single, childless, and have big incomes. (Hard for me to work up a head of steam of tax-sympathy for someone in that situation!)
The upshot of it is, putting a bunch of pre-tax income in a 401K is terrific, but the tax savings (at least in our family) are way oversold. Likewise with other “tax-advantaged” stuff, like dependent care accounts–it ends up being a big bureaucratic kerfuffle, and keeps extra money tied up til the expense is reimbursed, for a total tax advantage of what? A hundred bucks a year or so? Not. worth. it.
Ranks right up there with taking out a bigger mortgage “for the tax deduction”. Yeah, you can deduct a fraction of it–after the first $10K (for a married couple) has left your possession forever.
Pardon the rant! I’m in full-metal tax mode these days, and seeing that calculation casually tossed in always irks me.
February 6th, 2007 at 9:09 am
Angie,
Not to disagree, but when making a decision based on tax rates you need to look at the marginal rate of taxes (the highest bracket of taxes paid) instead of the average rate of taxes. Here is an over simplified example.
Say you have have a $15,000 income and no deductions exemptions or anything.
Here are the tax brackets for the example.
5% on First 5,000 = $250
10% on 5,001-10,000 = $500
15% on 10,001-15,000 = $750
Total Taxes= 1,500
Average Tax rate =(1,500/15,000) =10%
Marginal Tax rate = 15%
If you contribute $5000 to a 401k you actually void paying $750 in taxes because you don’t report the last $5,000. You save 15% of what is put into a 401k no the average rate of 10%.
The home mortgage is comment is very apt. If you don’t have other things like giving, other taxes, and medical expenses to fill up the first 10K+ of Standard deductions your benefit from interest on a home loan will not be near your marginal rate.
Tax credits should not be considered as part of the marginal tax rate either because they don’t effect the benefits from a tax deduction, but credits should be sought out.
The key is if you earned one more dollar what would it be taxed at and that is what the tax savings of most deductions would be.
February 6th, 2007 at 9:12 am
This is definitely a case of mind over matter. In the sense that the numbers are not as important a how it makes you feel.
I wouldn’t like to get out of the habit of putting away money for retirement, in case I forgot to start it up again. Also debts pretty much force you to repay them, either in the form of a minimum payment or a repayment schedule.
On the other hand, I wouldn’t like to have lots debt hanging over me either, I’d want to repay it quickly. So I guess I’d contribute a bit to both.
Working out which would provide the better rate of return never even occurred to me.
February 6th, 2007 at 9:25 am
Here is an idea I’ve been kicking around for awhile: why not bolster your emergency fund, then when that builds to a magic loan payoff point, deplete it and start again?
For example, my second mortgage is about $25K. I plan to maximize my cashflow over the next 10 months by strategically paying down certain nuisance loans and my remaining credit debt. After that, I will have a huge (to me) monthly cashflow I have to decide whether to invest or pay down more debt. But at that point paying down more debt will not increase cashflow, so I’m leaning towards putting it into a high yield savings, then when it reaches $25K in a couple years, *then* paying down that 2nd mortgage.
The obvious benefit I can think of with this plan is that money will be there for emergencies that are sure to come up in the next couple years.
February 6th, 2007 at 9:32 am
This is another case (like the Debt Snowball) where I don’t understand how this is even an issue. If you have high-interest debt, it should be paid off first, no matter what. Paying off a debt that is charging 15% interest is like getting a guaranteed 15% return on your investments, which practically anyone would say is a no-brainer. Instead of “Getting in the habit of saving”, get into the habit of paying off your debt and then put that same amount into savings once it’s paid off. It’s the same behavior (taking money from your paycheck and applying it towards something). How is it psychologically so different?
February 6th, 2007 at 9:32 am
http://probargainhunter.com/2007/01/31/top-30-personal-finance-blogs-by-feedburner/
Contrats man!
February 6th, 2007 at 9:42 am
Put your money where the biggest return is. If you are an automaton, or automaton-like, then you can run figures. Obviously, something with company matching that gives you returns of 50% or more is probably going to be the best place to put something. Then high-interest credit card debt, etc.
If you are not automaton-like, then psychological aspects should be considered. But it’s not just what makes you feel better (at least not directly). It’s still what gives you the highest return. Whatever method inspires you to scrape together the most money is probably going to have the highest real return (as opposed to whatever the highest hypothetical return would be if all scenarios were equally motivating).
February 6th, 2007 at 9:48 am
@ Mark: I think what Angie is saying is that after all her exemptions, deductions, etc., her taxable income ends up putting her in a lower tax bracket than she thought she was, so even using the marginal tax rate she doesn’t see as much tax benefit as she would expect. Here in the province of Québec (the highest-taxed jurisdiction in North America), I’m in the 52% tax bracket but when I look back at my taxes I see that I’ve only had to pay 37% after deductions and exemptions.
February 6th, 2007 at 9:58 am
Oh, I do have an addendum to make. A big one!
If doing one method makes you feel much better–like you can more easily sleep at night and you feel more successful and on track with your life, then your choice is easy–do the one that makes you feel better. Because all of that highest-return stuff is just so that you have more money to improve your life. If it’s easier to improve your life with a different strategy than with (a bit) more money, then that’s the right choice. I didn’t mean to imply otherwise.
My first answer was more for people who are having trouble deciding, which implies that it wouldn’t make a very big difference to them psychologically.
February 6th, 2007 at 11:05 am
Hey JD,
When you said you were quoting me, I think you were going to pick out this part,”The debt will get taken care of, but if I don’t start saving, I never will.”
I think it is a psychological thing. The debt will get paid because I’ve done it before, but turning myself into a saver was the bigger hurdle.
February 6th, 2007 at 11:11 am
Our strategy is to continue paying down debt and max the 401K because that is where the free money comes in when matched by the company. After 401K is maxed we aggressively pay down our debt.
After our debt is paid off we can completely concentrate on the 401K and savings.
I think that age could be a factor as well.
February 6th, 2007 at 11:32 am
I forgot about companies that match 401(k) contributions. That is a very good deal and should be maxed out. An immediate 100% return is obviously better than paying off debt at 15%.
February 6th, 2007 at 11:57 am
Lots of great points on balancing the financial decision with the psychological aspects. I like to think of it as a choice between a guaranteed return for paying off debt, and potential returns for saving/investing.
If I had credit card debt, is it better to get a guaranteed 18% return, or a possible 8% in stocks, or a guaranteed 5% in treasury bonds? Clear choice…
What about my wife’s student loans with the New! Improved! higher interest rate (7%)? In my mind, the decision is pretty close. We’d like to have lower monthly obligations in the future so we pay off extra, with money beyond our standard monthly retirement savings.
The 4.875% mortgage rate? I get a slightly higher rate of return with treasury bills, also guaranteed, and likely higher returns with retirements savings in stocks. No rush to pay off that debt
In my view, the retirement savings should be the easiest thing to do and not a “habit” to develop. Figure out what you could possibly afford to not have, and have it put directly into a 401K, or direct investment into a Roth IRA a few days after your paycheck is deposited. Don’t give yourself the chance to choose between retirement, or those pretty blue Keen shoes over at REI.
February 6th, 2007 at 3:40 pm
Let me put it to you this way:
Would you put a 401K on a credit card?
That is what you are doing if you don’t pay off your CC’s (and cut them up) before you invest in a 401K.
And I would always fund a Roth up to the max, and then the 401K up to 14% (the match is a bonus in my book).
Pay off you debt and you can afford to do it!
February 6th, 2007 at 5:03 pm
I think your perspective really will depend a lot on age. As somebody nearing 40, my retirement savings has started mattering more and more to me. I see the time getting shorter during which I can capitalize on the magic of compounding interest that hits your long-term investments at some point.
I’ve been adhering (mostly) to Dave Ramsey’s plan — I modified it so that I continued to contribute 3% to my 401(k) to get my company’s match of 100% of the first 3%. Truth be told, I’m really disappointed in how little has accumulated in the past year and a half that I’ve been debt snowballing. Since I have another 12-18 months to go on the credit cards anyway, I decided to let it take a little longer and up the retirement. So now I’ll be contributing 9% to my 401(k), plus $300/mo to a Roth IRA. This plus the company match puts me at roughly 14-15% a month being put towards retirement. That still leaves me enough to pay extra on my credit cards — PLUS it gives me a shot at qualifying for the student loan interest deduction, which otherwise I make too much to qualify for.
I admit, it does help that my outstanding credit debt is at 0% and 3.49% respectively.
February 6th, 2007 at 8:00 pm
Mark, thanks for the reply. Your example is oversimplified–so much so that it kind of makes my point. Last year the standard deduction for someone who was unmarried unmarried (non head of household) was $5000. Each exemption, including that of the person filing the form, took $3200 off the AGI. No situation where you can’t have at least that much off the top.
So, someone who’s unmarried and has no dependents makes $15K gross, but only has to pay taxes on $15,000 - 8200 = 7800 of it. By your chart, that’s a tax bill of ($250 + 0.1*2800) = $530
530/$15000= 3.4%
February 7th, 2007 at 2:00 pm
Angie
I will continue on your use of my example
No 401K:
Taxable Income(15000-5000-3200)= 6800
Taxes = 250 + (1800*.10)= 430
1800 Contributed to 401K adjustment to AGI:
Taxable Income (15000-1800-5000-3200) = 5000
Taxes = 250
Difference in taxes(this year but you pay back when you retire) for paying 1800 into 401k:
Difference
430-250=180
Difference/401k Funding
180/1800 = 10% saved by funding the 401K
In including the SD&PE did bring it down a tax bracket, but it is the marginal rate of taxes not the average that showed the amount of savings.
Average rate do not equal what is saved in taxes for Dollar for Dollar adjustment to AGI as a eligible 401K or student loan interest.
February 8th, 2007 at 5:08 pm
I have a lot of credit card debt. But it’s all on special balance transfer rates — including what used to be my school loans, which were at a higher rate (Sallie Mae sucks). I chose to pay more into retirement than debt because a) my rate of return for my _savings_ account is mostly higher than my interrest for the credit cards, and the retirement accounts are better than that; and b) the lack of retirement was making me nervous. Besides, I want to retire early.
The debt isn’t _increasing,_ however, and I believe I’ll be able to do the crazy-retirement-funding this coming year and start paying the debt down. This only works because I know that my debt, once paid down, will stay paid down, while the retirement funds will keep compounding. If I were a different person, I might well come to an entirely different conclusion.
February 10th, 2007 at 12:18 pm
I disagree on focusing on the opportunity costs of saving while you are in debt for a couple of reasons. First, I do not think you should make the choice between retirement and paying off debt. There are reasons for why you got into debt to begin with. Retirement savings is locked in and you will pay a hefty price for drawing into them if an emergency arises (which isn’t calculated above). So I would say to forego retirement savings in lieu of building your emergency fund and paying off debt first. If your employer does offer matching 401k, i’d be willing to increase the debt repay timeline in favor of capitalizing on it regardless of the size of your contribution.
Second, having a cushion while you are in debt will help alleviate going further into debt. The opportunity cost of saving versus paying off debt would logically point you towards paying off debt; however, as in my first point, you need the cushion for the unexpected. The opportunity costs goes away if you incur more debt or if you cannot gain more credit and things go into collections or you must file for bankrupcy.
Third, your debt didn’t come out of thin air. More often than not, it was because of your uncontrolled spending. Breaking the habit is what is important. Integrating saving into your life is breaking your habit of spending freely. You can eventually get out of debt, but you have to also focus on post-debt life. You do this by setting up your behavior to continue once your debts are paid off.
March 3rd, 2007 at 9:48 am
[...] Feb. 6th: Retirement savings or debt reduction: Which is the top priority? [...]
August 9th, 2007 at 1:17 am
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