Real-life choices: Retirement savings vs. debt reduction
I’ve accumulated $3500 and I don’t know what to do with it.
As you may recall, I am carrying the remainder of my credit card debt in the form of a home-equity loan (or HELOC). The current balance on this debt is $15,000 and I’m paying a 9.25% finance charge. I intend to have this debt eliminated by March 2008. It’s an ambitious goal.
In order to make this happen, I’ve had to forego investing in my Roth IRA. I established this retirement account last spring, but only put $650 into it before focusing on the HELOC. Now I have the money to fully fund it, but don’t know whether to do so, or to continue attacking the debt aggressively. There’s a time-pressure to this decision: Roth IRA contributions for 2006 must be completed by April 17th.
On the surface, this seems like a no-brainer. By paying the $3500 toward the HELOC, I’d be saving $26.98 per month in finance charges. That’s a lot of money! But since I intend to have this debt repaid within a year anyhow, my maximum savings is only about $325. There are strong arguments for putting the money into my Roth IRA, despite the lack of a guaranteed return.
Here are the factors that weigh in my decision:
- Once the funding deadline has passed, I can never put money into the 2006 IRA again.
- If I fund the 2006 IRA, there’s no guarantee that I’ll have the money to fund an IRA for 2007.
- If I put the money into the IRA, I will invest in an index fund.
- By paying down the HELOC, I am earning 9.25% on my money, but it’s a one-year return. That is, after a year the HELOC will be gone and the returns will no longer compound.
- Though funding the IRA may return less than 9.25% over the next year, the money will continue to compound over time.
- If something goes wrong and my income declines, I will much rather have paid down my debt.
- Debt reduction has a bigger psychological payoff than retirement savings. The debt is a burden.
- In the long run, the IRA is the best choice with regard to taxes.
- There’s an income ceiling to Roth IRA contributions. If a couple makes more than $160,000/year, they cannot contribute to them. We don’t make anything near $160,000 right now, but we may in the future. And if we do, we’ll no longer be able to add money to our Roth IRAs.
Which one will I choose? I’m going to fund the retirement plan.
Why?
I seem to have licked the Debt Monster. I stopped acquiring new debt long ago. Complete debt elimination is so close now that I can taste it. It’s a priority. Debt is no longer a psychological barrier for me, but saving for retirement is. When I think of how little I have saved, I panic. I must start saving, and funding my Roth for 2006 would be an awesome first step.
I moved the money into my retirement account last night. Now I need to decide which index fund(s) to purchase. I thought the decision would be easy. It’s not. Though my account only allows me to purchase exchange-traded funds, there are still dozens of options: QQQQ, SPY, IWM, EFA, VTI, TIP, etc. It’s like alphabet soup.
Note: This is the best choice for me and my circumstances. It’s not necessarily the best decision for everyone choosing between debt reduction and retirement savings. Do what works for you!
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There are 42 comments to "Real-life choices: Retirement savings vs. debt reduction".
I agree with you. It is a tough decision. Logically if everything goes right, it may make sense to fund the ROT IRA (Assuming you are young and your incode is only going to increase over time).
But looking at all your questions and thoughts, to me it seems peace of mind should be at the top of your list and hence I would pay off the debt first. That is the safest path.
Normally I would say pay the debt off as quickly as possible, but I read an article a while back mentioning how costly it was to miss just ONE YEAR of IRA contributions (in the long run). I think you’re making the right choice in funding the IRA.
Since your funding a roth you can still get to your money and pay down debt with it so I would not put much emphasis on:
“If something goes wrong and my income declines, I will much rather have paid down my debt.”
I believe you should pay off all debts before investing (except home).
I think you should consider looking from this perspective: In its simplest form, debt is using someone else’s money to pay for something else. You get the satisfaction of having the good now, but you have just waved the right to keeping a specified amount of your future income.
You currently owe $15,000. And you have $3500. How did you accumulate this extra $3500? Through savings? Was it a gift? Selling off an asset? Whether or not this money was “unexpected” or “earned” you should take the opportunity to free up your future income and pay down this debt.
The basic principal of saving is living on less than you make. By putting that money aside in a retirement account you are not doing so. Simply put, you are living on more than you actually have. Its obvious you are more savvy and have made responsible decisions to turn your finances around–but borrowing is what got you into your current mess–you need to clean it now.
I understand the opportunity cost of investing early and in the end the difference between paying off that balance will seem negligible–however you are basically demonstrating to your readers that you have not really learned your lesson–you are just shuffling your money around in a different way. Even with your current game plan of paying down that debt over the next year — its just a plan, life happens.
As a 22-year-old college student, who put himself through school. I am about to graduate with absolutely no debt. That’s right, $0. I also have $15,000 in retirement accounts and will be able to purchase my first home as soon as I graduate. I can tell you that investing is a lot easier when you don’t owe anyone anything. You are trying to do 2 things at once (saving & paying down debt).
I don’t think your move is ignorant, just misguided. Even though you are paying yourself by investing that money–you are still leveraging your previous debt to do it. Your retirement will grow, but you need to take care of your current obligations beforehand.
Best of luck, I enjoy reading your blog.
A fine choice. I’ve gone in the opposite direction, choosing the psychological debt-reduction path rather than regimented investing, but I can definitely see your point of view.
Sounds like you’re definitely sticking to your plan. This type of “problem” is the best kind to have 🙂 Whenever I hear a question like “what do I do with all this money?”, it makes me smile. Congrats on the good news!
I would pay the $3500 down on my HELOC. Then I would divide $3500/38 weeks left in this year = $113.16. Decrease my loan payments by that amount and fund my IRA each week for the next 38 weeks.
This way, I save money on my loan and gain through dollar cost averaging.
Just a thought!
I disagree with Justin that you should, as a matter of rule, pay off all debts before investing. However, I agree with him on many other points. I seem to be only a year his senior, and also graduated with $0 debt. (In reality it was $800 from a student loan that I leveraged until the month before the interest was to begin, and then easily paid off in full.) I agree fully that with no debt, investing and leveraging your actual worth becomes much much easier. Debt’s an evil monster, but that is by no means a certainty written in stone. In all likelihood, we’d agree on many things, but not this.
There is one statement that should convince everyone that you are making the right choice, and it is the following: “But since I intend to have this debt repaid within a year anyhow, my maximum savings is only about $325.” He goes on to say that he understands the opportunity costs, but I don’t understand how one can understand the opportunity costs, and disagree with your decision. Much as I could have paid off my student loan in full years before I did, why would I have? I paid no interest on it, yet it was still a debt to my name. Obviously in your case you will be paying interest, but the $325 that you’re spending to invest now is not only worth it, but advised.
I also disagree that you’re setting a poor example or this is a poor display of debt management. Obviously I would not advice people to run up debt to invest with, but one must not go to the opposite extreme. Debt is simply one factor in your entire economic situation, and by taking a narrow view, I think many people miss the larger picture, or don’t necessarily believe in considering the entire scope. You are better served (if you actually pay it off next year!) to invest now before the deadline. I think you are doing exactly what you say, in “managing” your debt perfectly in this case. This is a controlled decision, and one that is mathematically sound.
I’m of the pay debt debt first camp. You never know what the market’s going to do, you never know what might happen to your job, family, etc. As long as your interest rate is higher than what you can reasonably depend upon in the market, I’d always go with debt first (except for house).
Everyone seems to be debating the issue (pay down debt vs. invest) and missing that the article closes with a question. JD has already mailed the check and made a good choice since either path was pretty good and he shouldn’t lose any sleep over which one was optimal.
As for his question, he wants to know which index fund to purchase and also mentions something about his broker offering exchange traded funds. I’ll let someone else recommend a fund, but I’ll say that there is really no difference between an index fund and an ETF when used in a tax advantaged account. Many people prefer an ETF for taxable accounts because you pay taxes when you sell the fund, thereby giving you more control over its tax designation as long term. This poses no advantage in a ROTH, so if an index fund holds roughly the same underlying issues as an ETF but has a lower expense ratio it is a no brainer to go with the index fund.
There are, of course, other considerations but I’ll let stop now and let the peanut gallery chime in with answers.
I would have (and have myself) chosen the IRA as well. It worked out for me, hopefully it will for you too. Good luck!
Good job JD! Both options are good choices; it just comes down to your risk tolerance. Also it’s good to remember that you can withdraw your contributions from your Roth at any time penalty free, so it’s not as risky as you may think, liquidity wise.
Debt is just a tool. You are using debt in a very correct way: to increase your net worth. It is not living beyond your means as your Roth IRA money is not “living” money.
Also I’m glad to see you avoiding the psychological gain for the probable numerical one. Psychological gains may feel good, but they don’t factor into your balance sheet anywhere. I think this move shows how your financal thinking is maturing.
Why choose?
Why not split it into two?
This is similar to the classic fund retirement or pay off the mortgage debate except with smaller dollars and shorter time frames. The hubby and I decided to split our investable cash between the two. A means of diversification.
As for index funds, I find myself mostly drifting towards Vanguard’s Index ETFs. They have super low expenses and being ETFs are quite liquid.
I’m rather young, so my portfolio is a bit aggresive with lots of international equities and domestic small caps with some large cap values mixed in.
Technically, paying off debt would make more sense for your financial bottom line since you would need to come up with an investment that can beat 9.25% of your Heloc.
However, the tangibles make your decision a good one:
1. See money in your retirement account (makes you happier and motivates you to save more)
2. If you pay off your debt, your future money might not be going into savings (your comics book dilemma again) but if you put in your $3500 money in your retirement account, the future will most likely be used to pay off debt.
In the end, it is almost impossible to figured out what really worked out best since there is absolutely no way to calculate what the behavioral of each decision will bring in the future. Just know that what you are doing (paying off debt and/or putting money in retirement accounts) are both good choices so you can sleep happier everynight.
My Own Millions Blog
Two thoughts:
1. Why would you take out $3,500 on a HELOC to invest in the stock market? Why not take out whatever you need to fully fund that IRA?
2. You are not taking into account risk. The money in the IRA is at risk, where the debt also adds risk to your life.
I am also not sure the math works out if you take into account inflation, almost seems like you are taking a negative net rate of return (depending on the investment vehicle you choose).
I would have paid down the debt. JD essentially borrowed money @9.25% to contribute to retirement. Not the smartest move IMO.
I disagree with Jason for two reasons. 1.) He already has a plan and funds in place to pay off his debt over the next year. And 2.) His potential benefit outweighs the cost. Simplified example: Yes, he is essentially borrowing money at 9.25% to fund his retirement account into an index fund. On his current plan he still pays off his debt next year. He missed out on $325 of potential savings. Now let’s say he earned 10% on his IRA, He made $350. He’s already ahead of the game. The kicker here is that next year he earns additional interest, and the next year, and the next year…
It’s smart mathmatically, and since this is a well thought out idea that takes into account his debt. It is the opposite of haphazard. Is he slightly leveraged? Yes. But if something really terrible happens and he absolutely needs the money, he can pay the penalty and still get his money out.
My personal preference ( what I would do in an ideal world, not that I do)and belief is I would fully fund retirement options prior to anything else at all. That means before anything, my actual spendable income might as well pretend that money doesn’t even exist- like a tax or other deduction that my net never sees.
I am not a big fan of debt, but I believe one can do both- pay down debt and invest for retirement. And I consider the latter a requirement- it might as well be like income tax or FICA,etc. Iit’s like a tax to myself. The money isn’t even available for spending, and the debt will be paid down through other available income,etc.
My math might not be correct, but in my eyes/life debt gets paid down regardless ( and a HELOC being a fairly “cheap” debt option)but $4000 has the chance to grow and compound for several decades. I dont see how ( long term) paying a fairly low rate debt down by a few grand can come close to what investing a few grand ( with tax-free growth) might do.
Take 975 and have an even $1000 for emergencies, then pay off the debt. Don’t forget you have the Roth ‘Catch Up’ option to add addtionalin funds on top of the limits, and you’ll certainly be more focused on investing once the debt’s eliminated. The mental freedom of no debt outweighs the benefits of the retirement funds, imho.
Tough choice, JD. I’m glad you picked the Roth, and I think this is the correct go-to decision for most people. If they’re so in debt that they can’t save for retirement, it’s time to start thinking about the big “b”. And, just a thought, but don’t you actually save more that 9% in taxes?
I would have put the money towards the debt snowball, mainly because I’m a Dave Ramsey fanboi, but also because of what he specifically asks many times:
If you didn’t have $3500, would you borrow against your IRA to get it?
Most often it is a question of borrowing against the house, but sometimes other situations come up. This is quite common on his show.
Since you’re restricted to ETFs only…
I like Vanguard funds, but not the one (Vanguard’s Total Stock Market [VTI]) on your list. Its returns since its inception in 2001 have only been 4.75%. I know you’re thinking long term, but you could still do better. Among Vanguard’s other ETFs, I’d choose between Vanguard’s Value ETF (VTV), Extended Market ETF (VXF), and – if you want to go outside the U.S. – the Emerging Markets ETF (VWO).
Do you have Sharebuilder as your broker, by chance? I originally started with them, only to discover I was restricted to stocks and ETFs.
@frank: Don’t forget you have the Roth ‘Catch Up’ option to add additional funds on top of the limits
What do you mean exactly? The Roth limits are just that: limits. You can’t contribute more than the limit.
The possible opportunities to “catch up” are two:
a) you have until April 15th (April 17th this year) to make the previous year’s contribution, and
b) the contribution limit increases at age 50 and above (currently $4000 to $5000).
Beyond April 15th, if you missed a year then the opportunity is gone forever. And if you wait until you’re 50 to catch up with increased contributions, you’ve missed out on many years of (potential) investment gains.
It seems to me that yet again this is a psychological-vs-practical decision: JD knows he has the commitment and the means to deal with his debt this year, and he feels (in his words) panic about retirement savings. Although paying down the debt might be the logical choice, investing in retirement sounds like it’ll help him sleep more easily.
And avoiding these last-minute agonies of choice is why automatic monthly Roth contributions are good: once they’re set up you’re automatically paying yourself first and you may well not miss the money.
JD stopped contributions to focus on debt, which was a higher priority for him at the time — but as this post shows, those priorities have shifted. Maybe setting up a smaller automatic Roth contribution, so that he’s making some retirement savings while still attacking his HELOC, would strike a more comfortable balance?
JD:
In a similar situation I’ve put 50% of the money into VTI, and 50% into VEU, the new Vanguard International (ex-USA) ETF.
I can’t say this is the right choice for you but it was for me.
@Kevin: you could still do better
But — and this is important — at higher risk. (Everything in Emerging Markets, for example, would be extremely risky.)
Well I sent my response and had further thoughts:
1. My reasons for going with VEU are that true to Vanguard index funds it has a low expense ratio. Even more importantly is that it is the only broad-based international ETF that includes Canada. Typically Canada is excluded from international ETFs, and if it is represented in a US ETF it is always some tiny fraction of a percent. Why is Canada so attractive? The oil sands and other natural resources companies are poised to be very hot over the intermediate- to long-term.
2. I go with 50/50 US to international due to certain of my outlooks for the future. If that’s too aggressive to you JD, then go with 60/40 or 70/30 US to international. IMHO opinion though, you would do well to consider how much you want to invest internationally and stick to it — don’t wait to do it, do it now. Don’t put all your eggs in the US’s basket, and keep in mind that I think the conventional wisdom on how much should be international understates it. I care more about you diversifying out of the US than I do which specific ETFs you pick.
JD if you want to discuss this further feel free to email me.
DB
James Kew: “But – and this is important – at higher risk. (Everything in Emerging Markets, for example, would be extremely risky.)”
True. I’m all for being conservative when it comes to money. But in the context of the above discussion, I should point out two things:
1) We’re talking long term. If he needs this money within three years, *r*i*s*k* are the last four letters he should want to see. But since this is retirement money and he’s still quite young, a little risk vs. reward is a good thing. Obviously, that doesn’t mean you invest everything you own in a penny stock, but you get the idea.
2)An online savings account can get you 4.75%. It’s a solid return that beats inflation. But for a retirement fund, 4.75% just doesn’t cut it. An ETF that has only gotten 4.75% during its entire existence – an existence spent primarily in a bull market – is not what you should put your IRA money into.
I don’t think J.D. made a bad decision, but I’m not convinced it’s 100% correct. On a strictly financial basis, I think paying off the debt would be better — a guaranteed 9.25% for paying off debt, vs. an unknown return from the investments.
What would sway me?
1) Knowing you’ll have enough additional money in 2008 to fully fund your Roth. Contributing now gives you an additional tax break over just contributing the same amount, but at a later date. (In other words, having a “spare” $3500 at the end of 2008 that you can’t contribute to your Roth would be “bad”.) Seems likely, which edges me toward agreeing with your decision.
2) If you suspect you might get a little sloppy saving for retirement once the debt is gone. You know, like giving yourself a reward for paying off debt that eats into retirement savings. (“I did such a good job, I deserve a new MacBook Pro!”) For this latter reason, I split the difference on paying down my 8% car loan and funding my Roth.
3) Secret stock tips. If the market is poised to take off, heck, why not take a little risk for fun?
First off, that is one good problem to have. I wish I’m face with the issue of where to put the extra $3500 everyday =)
I think you made the right move for yourself. One thing you can do is once you pay off your debt, calculate how much you’ve earned in your Roth IRA and see if it was indeed a good move. If you find that you actually made less than 9.25% you would have otherwise saved by paying off your debt, then bump up your Roth IRA contribution to make up for it. Otherwise, if you made more than 9.25% in your Roth IRA, then even better =)
Regardless, you made the move that’s best for you. Something you won’t lose sleep over. I think it’s a win-win situation, better than blowing it off on comics =D
I’m afraid I’d have gone for reducing the debt too. By my way of thinking removing a 9.25% expense this year is a great return many years. If you think of that $350 in interest you might pay this year as a “transaction fee” on your $3500 investment…. Since you are considering index funds I suspect you’d not accept a 10% load.
But if you were going to do the IRA, then I’d say ETFs. You’re making one block investment rather than a series of equal investments. Find a discount broker like Firstrade.com and buy 1-3 ETFs and select dividend reinvestment.
There’s usually no fee for your first few trades when you open an account with a reasonable sum, and the fees are lower forever.
My recommendation is reasonably moderate:
45% VTI
15% EFA
40% AGG
It’s a standard 60/40 portfolio with 25% of the equity exposure non-US. I like VEU for that (instead of EFA) as well, but EFA is well-established and not so thinly traded as VEU right now.
If you ever get sick of your discount broker, you should be able to transfer your shares to another broker without even having to be out of market. You don’t have to worry about missing an up week and getting trashed.
I *AM* convinced JD made the 100% correct decision. He is starting to save late, and the power of compounding ONLY works in the long-term. His debt is under control, and funding that Roth is BY FAR the best decision, especially when we look at in its expected value.
EV(323.75) in 10 years is 323.75/(1+3%inflation)+ 9 years 323.75*(1+7%realreturn)^9.
EV(3500) in 10 years is 3500^ert. or 7,048.13
So obviously, saving yourself first when your debt is under control is the best choice possible.
Oh, I would echo exposing yourself to internaitonl markets with the vanguard fund described above
Re Kevin, I don’t think you can dis’ VTI because its lifetime return has been 4.75%. Pointing out that the market has been predominantly bullish during the period doesn’t reflect a particularly deep perspective either. Losses hurt more than gains help.
Over the period, VTI bested the S&P 500. You rarely hear people complain that a savings account could have done better than the S&P, even during market declines. Indeed, given the period (including the bear and bull parts), VTI did very respectably.
There are strengths to dividend heavy stocks (suggested by someone), and they have in fact done well recently. Historical perspectives support the strategy as well. But there’s nothing shameful in grabbing up something like VTI. I’d be completely unsurprised 5 years from now to discover that VTI performed well compared to your suggestions today.
We could run into an economic slowdown (inflation anyone?) and small and medium caps could lag. We could see an emerging market disappointment; they’ve been strong for some time now. We just don’t know.
Hypothetically, I wouldn’t start dismissing foreign investment just because a few years were weak. It would be better to stick to a strategy. Chasing gains is a documented-poor strategy. Similarly, you can’t really discount VTI. Its lifetime return has been okay given market conditions. To ignore it because of near history might be to overlook opportunity.
This is the question that I wondered about the most: How much to Invest vs. Debt Repayment. I am currently in $230k of student loan debt and am finally making an decent income. I have calculaated the scenarios 30 years into the future: attack the debt 100% and then invest once they are paid off, 50%/50% invest (IRA and equity mutual funds) and debt repayment, fund IRA and use the rest for debt repayment. They end up all being pretty close and I have decided that funding the IRA and using the rest for debt is what works best for me. Has anyone else calculated these scenarios?
I’m satisfied with VTI, personally. I also just got into VEU (along with everybody, it’s that new) but I have confidence in it over the long term.
And JD, I think you made the right choice. Not only that but I’m envious that you got to do it and I didn’t — I only managed $500 into the Roth this year. Perhaps it isn’t as good on paper, but I don’t think it’s going to knock you off your debt repayment.
DB
OHHHH, Jim….let me shake your hand. Finally somebody with a bigger student loan than me (~$191K)
Jim, all I can tell you is that I am not willing to be paying on this loan for the next 30 years. NO — I will not have my entire adult life that enslaved to it. I’m just a few months away from being able to start sending in double payments on it, and have run the figures that if I do stick to my plan I can get it paid off in 9-11 years, give or take.
That’s assuming I can avoid layoffs, and stay employed at a company making my current salary (or better) as well as a nice big bonus each year. If I manage to get a side business going I’ll through all my profit at the student loans too.
In the meantime, I’m going to be contributing 9% to my 401(k) and putting $150 into my Roth IRA each month, as well as putting $150 into straight savings each month. I’ll also save $1K out of my yearly bonus in my Roth IRA and in my straight savings. I won’t fully fund my Roth IRA but will get close.
DB
P.S. — I haven’t started this yet, I’m still on my credit card repayment percentages which are lower. In July I plan to shift my percentages.
I agree with your decision. And most of your points, except for the second one. Maybe over the next year you WILL have the money to fund your 2007 Roth IRA contribution. But the opportunity to fund your 2006 Roth IRA expires next week.
I think Jason made the wise choice. For one, the 9.25% interest he’s paying is for only one more year … it’s not going to get much chance to compound. Look at it as being simple interest. (The debt compounds but the principal is in free-fall). For another, in a few months, the money put into the Roth will be but a vague memory … and hard at work for many years yet to come.
In a year, he’s debt free with money in the bank, self-discipline and many years ahead of him to fund his dreams.
Done deal, in my book.
I’m also of the pay down the debt camp. Paying down the HELOC is essentially a guaranteed 9.25% return, where as the market can be anywhere…
Contributing to the Roth IRA will reward you handsomely over the long run. $3000 compounded for 20 years at 6% will give you a total of $9621.41. That’s all tax free. So you are talking about of $6621.41 that you don’t have to pay tax on. If your tax bracket is 28% when you withdraw the money, that’s an additional $1853.99 that you don’t have to pay.
Definitely max out your retirement savings because the tax laws for the retirement savings is more favourable.
The other thing, your debt is in your home equity line, so that interest is tax deductible. That $27 per month finance charge is tax deductible, so if your tax bracket is 28%, then your finance charge per month is only 27-27*0.28=19.44. So really you talking about 20 bucks. Peanuts compared to the amount save with the Roth IRA.
http://wisdomfrommywife.blogspot.com
Both need to be done at the same time, there needs to be a nice balance
At the beginning of 2005 I had 60,000 of Debt (car, student loans and cc debt) I got a 2nd job and have been working this in the winter months. I am exhausted but am down to 13,000 of debt. I decided to pay all of my debt off first then I will start saving like a mad man. Come what May I will be debt free and alive again…I love this site