Debt Reduction vs. Retirement Savings

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Debt.  Saving.  Retirement.  What should we do?

This topic of retirement savings vs. debt reduction is becoming one of my favorites here on DFA.  Looks like I’m not alone!

Today I received this email from DFA reader Bruce in reference to the family budget spreadsheet I released yesterday.

In the last post I noticed that there was no retirement savings entry in the spreadsheet  you posted.  As the rest of the Budget Spreadsheet was so well thought out , I can only assume that this was by design.  Did you decide that paying off debt was more critical then saving for retirement?

I have been trying to work out what I need to retire, and what will give me the best boost financially, either paying down debt first and then saving for the future, or trying to do both at once.  Any thoughts to share, maybe on a future post?

Thanks in advance

– Bruce

Thanks for the question and great topic Bruce!

I will quickly answer your spreadsheet question, then move on to address the main concern you raise about funding retirement savings or focusing on debt reduction.

While I did not create a dedicated section for retirement savings in the family budget spreadsheet, the amounts can be added to the “Savings” section.  I did this because I, like most American’s, have outstanding debt at a high interest rate, and am not in a situation where I should be contributing to retirement savings.

Should you focus on retirement savings or debt reduction?

Are you like DFA reader Bruce?  You know you have debt, and you know you should be focusing on debt reduction… but at the same time you keep hearing about compound interest and how you should begin your retirement savings as soon as possible.

It can sound confusing… but really it’s not.  A few simple math computations will show us what is best for each or our own individual scenario.  And beyond that, usually we can determine our best plan of action based on a few simple criteria… I have covered these criteria at length in past articles.

Questions to consider…

  1. How much debt do you have, and at what rates? This should be your first concern when attempting to formulate the best retirement savings plan for your unique situation.
  2. How old are you? Even though this question is often given too much attention and focus by retirement planning “specialists”, it is still an important consideration nonetheless.  Just make sure you do not let someone scare you into investing because you are a certain age and have not begun your retirement savings.
  3. Do you have access to a tax sheltered plan? Chances are you do.  If you do not have access to a business 401k plan, a 403b, or an SEP retirement plan, go open a Roth IRA.  Most people are eligible for a Roth IRA and stand to realize huge benefits by getting started with one as soon as your debt amounts allow.
  4. Do you have an employer match? If so, consider all your financial variables before blindly contributing just because everyone says you should.  Is it a fully vested plan from the get go… or do you earn 20% vesting each year?  How stable is your employment… and do you plan on staying with that employer for years?
  5. Can you contribute to retirement savings and still pay for groceries? Don’t contribute to retirement savings if you doing so will hinder your ability to put food on the table.  You have to keep your priorities straight and trust God with the details.

Debt Reduction vs. Retirement Savings archives on DFA

Here are some articles I have written in the past on this exact subject:

Debt Reduction Focus

In a nutshell… it is not in your best interest to concern yourself with retirement savings if:

  1. You still have credit debt or any debt at a high interest rate.
  2. You do not have a fully funded high interest rate savings already set up for emergency situations.

If either or both of these examples hit close to home, then you need to be focusing on debt reduction.

Retirement Savings Focus

You will want to contribute to retirement savings if:

  1. You have no debt.
  2. Your debt is not at a high interest rate.
  3. Your employer matches your retirement savings contributions, you are planning on being employed there long enough to become vested, and you still have enough money for groceries after contributing.

If any or all of these scenarios describe your situation then you should probably consider contributing to your retirement savings.

Balanced 75/25 Method of Debt Reduction and Savings

Long time readers of DFA will instantly recognize this approach!  I will summarize the concept below and customize to today’s topic.  If interested, here is a detailed read on the balanced 75/25 debt reduction and savings method.

The premise here is simple.  If you are not ready to contribute to retirement savings, and are constrained by your financial situation to focus on debt reduction – consider the 75/25 method for a balanced approach to saving while in debt reduction mode.

Some financial experts advise us to save $1,000 then abandon savings and focus solely on debt reduction.  Please remember that many of these concepts were formed at a time when the economy was much stronger than it is now.  Personally… I think the rules have changed.

Consider apportioning 75% of your available money to debt reduction and the other 25% toward an account with a high savings yield.  We did that for months, stopped for one month but felt uncomfortable about not saving at least something, so we resumed putting a portion of our money toward our accounts earning a high savings yield.

High Savings Yield Accounts

If you are in the market for a bank with a good high savings yield, check these out.  I prefer Capital One 360, but any of these are good.

[fintools savings | small]

If you were Bruce… what would you do?

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1 Paul @ FiscalGeek

I’m 100% behind the idea of clearing out your non-house related debt before busting the retirement if.. and it’s a big if… you are going to seriously attack the debt and get it done. If it’s going to take you years to get out, and you have the option of some kind of employer match I would at the very least at that point take my free money. But I’ve found that the laser guided focus of debt reduction works.

2 Matt Jabs

I currently fore go the employer match on my 401k and focus all efforts on necessary, immediate liquid savings… but mostly on debt reduction.

One reason I do not contribute is because I am only 20% vested and it will take another 4 years to become fully vested in their match. While I will get 100% of the match in 4 years, right now – as Paul said – the laser guided focus of debt reduction is my highest priority.

3 BG

I believe it was Dave Ramsey who summed this up nicely, when asked a question on whether to invest or pay off credit card debt. His answer was:

If you did not have any credit card debt today, would you immediately max them out and invest the money into the stock market? If the answer is no, then pay off the credit card debt, and forgo investing in the meantime.

By not paying the debt faster (and investing instead), then you quite literally are taking out a loan for investing/gambling. With high-interest CC debt, this is a no-brainer: pay off the debt! With lower interest debt, like mortgages, the answer is not so clear cut: so I do both: pay extra on the mortgage, and invest.

4 Melissa

My honest question (which I have considered often) is why the question you posed doesn’t work for the home debt as well. Would I borrow money on my home to invest for retirement? At my age, no. So why should I be investing for retirement before my home is paid for? Has any one thought through this and come up with a good answer?

5 Matt Jabs

I definitely see your point Melissa, but here is how I will explain why you should invest with just mortgage debt left.

In most circumstances, though not all of course, mortgage debt will be relatively low and quite beatable by the average yields from mutual funds over the life of the investment. So… my advice would be to invest about 15% of what you make and continue to use the rest for accelerated payment on the mortgage debt to get rid of it ASAP.

6 Kevin@OutOfYourRut

Another consideration is tax deductibily of mortgage interest. This makes mortgage interest a category unto itself. If we all waited until our mortgages were paid (15-30 years), none of us would get around to saving for retirement until… retirement. By then it’s too late.

7 Peter

I come down on the side of not contributing to retirement while you’re in debt, and getting “gazelle intense” on your debts from smallest to largest. I don’t think the decision is purely a math problem either – I think it is also about the psychological stress of having debt. When you have debt it just weighs you down and will cause some sleepless nights. To me it is priceless to get that debt paid off first, and then after saving up a nice emergency fund (especially in this economy), starting to save at least 15% – probably more – to your retirement accounts.,

Get rid of debt, then save for retirement is what I say!

8 Matt Jabs

This is my current plan, although as I mentioned earlier, we are putting some money away into our liquid money market account for added security during these unsure times.

9 Craig

I don’t have debt like that but it seems he should try to get rid of as much debt as possible before beginning to save.

10 Robert Espe

It isn’t just about where you can make the greatest %. Investing is by definition placing money at risk, therefore it must be money you can afford to lose, it must be “surplus”. If you have ANY debt, you by definition, have no surplus money. Any interest made by investing early would be wiped out if you tried to get at the money early to meet debt obligations in an unforeseen situation (like making house payments after a job loss).

“take heed those who say, next year we will go to such and such a city, engage in business for a year and make a great profit, for you do not even know what tomorrow will bring”

11 Matt Jabs

Great points Robert… it is better not to presume upon the future.

12 Kyle

I guess I will be that guy. I don’t necessarily agree with the kill the debt at the expense of everything else. I think it is is a good idea and would never tell anyone not to do it if they felt that was the best route for their family.

I look at my own situation and I don’t regret anything I have done. I have managed to reduce my debt to just my student loan which will be eliminated this year. We have paid off two cars and managed to save over $50,000 in retirement investments before we are 30. Compound interest is working in our favor and the more you save earlier in life the more that money can work for you in the future.

I think if you can set yourself up to pay off your debt in a reasonable amount of time and balance that with contributions to your retirement you will be well on your way to success. If you have massive amounts of unsecured credit card debt you should certainly work on that before you make big commitments to your retirement but balance is key.

13 Matt Jabs

Good points Kyle, but consider this. If you lost the bulk of your income you may be forced to use the investment gains to pay your debt obligations… which is the argument many made above.

Having debt = presuming future income will continue to roll in, and that in and of itself is a risk.

14 Ken

I like your 75/25 strategy. This would really work well for someone who doesn’t have an emergency fund but wants to build it while paying down debt. I think paying down debt is probably the best route…especially if it’s high interest.

15 Matt Jabs

Exactly Ken… it is important to save – especially in this economy.

16 Financial Samurai

Good set of questions to ask as I put up a new post on “Credit Cards As Weapons of Mass Destruction” today.

The first is to look inwards, and ask yourself if YOU have a problem with debt. If you don’t fix the core of the problem (YOU), then no matter how much you save, you’ll be taking it out to pay off your debt.

Once you understand the stupidity of getting into so much debt in the first place, THEN attack debt on a 80/20 level, with 20% being your savings.

Once your debt is eradicated then you’re free!

17 Matt Jabs

My sentiments exactly…

18 George

There is one small problem. What if we have high inflation and the dollar collapses? Then, our savings would be wiped out.

19 Matt Jabs

Well that is utterly out of our control… so all we can do is monitor the situation and adapt thereto.

While we MUST be prepared by way of commonsensical diversification of our financial assets, we CANNOT live in fear of circumstances out of our sphere of control.

There is wisdom in this question, just don’t get caught up in too many details.

20 Kevin@OutOfYourRut

It’s also worth considering what it is we’re investing in for retirement. Fixed investments like CDs and treasuries are safe, but they pay well below credit card rates. The stock market may be yielding more NOW, but how does it look if the market should take a 20-30% hit?

If we put money into retirement that could have been used to pay off debt and the market tanks there’ll be “wailing and gnashing of teeth”, but no way to change course.

We probably need to approach it asking “If our situations were to take a turn for the worse (job loss, market slide, etc), what WOULD have been the right course?” We tend to make our plans assuming that reality will cooperate with us, but that isn’t always the case.

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