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!

More about...Debt, Retirement

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Hari
Hari
13 years ago

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.

anonymous..
anonymous..
13 years ago

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.

Mark
Mark
13 years ago

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.”

Justin Byron
Justin Byron
13 years ago

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… Read more »

Wesley
Wesley
13 years ago

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!

D
D
13 years ago

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!

Nathan
Nathan
13 years ago

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… Read more »

Chance
Chance
13 years ago

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).

Duane Gran
Duane Gran
13 years ago

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… Read more »

savvy
savvy
13 years ago

I would have (and have myself) chosen the IRA as well. It worked out for me, hopefully it will for you too. Good luck!

GG
GG
13 years ago

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… Read more »

Kimber
Kimber
13 years ago

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.

GG
GG
13 years ago

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.

MyOwnMillions
MyOwnMillions
13 years ago

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… Read more »

Name
Name
13 years ago

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).

Jason
Jason
13 years ago

I would have paid down the debt. JD essentially borrowed money @9.25% to contribute to retirement. Not the smartest move IMO.

J.R.
J.R.
13 years ago

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… Read more »

Greg C.
Greg C.
13 years ago

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… Read more »

frank
frank
13 years ago

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.

Starving Artist
Starving Artist
13 years ago

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?

joshuat
joshuat
13 years ago

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.

Kevin
Kevin
13 years ago

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.

James Kew
James Kew
13 years ago

@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… Read more »

db
db
13 years ago

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.

James Kew
James Kew
13 years ago

@Kevin: you could still do better

But — and this is important — at higher risk. (Everything in Emerging Markets, for example, would be extremely risky.)

db
db
13 years ago

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… Read more »

Kevin
Kevin
13 years ago

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… Read more »

daniel
daniel
13 years ago

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… Read more »

Francis
Francis
13 years ago

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… Read more »

DonB
DonB
13 years ago

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… Read more »

DC Economist
DC Economist
13 years ago

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.

DC Economist
DC Economist
13 years ago

Oh, I would echo exposing yourself to internaitonl markets with the vanguard fund described above

DonB
DonB
13 years ago

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… Read more »

Jim
Jim
13 years ago

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… Read more »

db
db
13 years ago

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

db
db
13 years ago

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… Read more »

EMF
EMF
13 years ago

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.

BillinDetroit
BillinDetroit
13 years ago

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… Read more »

Me
Me
13 years ago

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…

The Hubby
The Hubby
13 years ago

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… Read more »

Steve "The Debt Settlement Man" B
Steve "The Debt Settlement Man" B
13 years ago

Both need to be done at the same time, there needs to be a nice balance

Jimbo
Jimbo
12 years ago

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

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