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Should I Use My Retirement To Pay Off Debt

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The question…

DFA reader Josh asked:

I am in the military and at the point were i can get a bonus of $30,000 if I reduce my retirement to 40% of my base pay at 20 years – or – stay with high 3, which is 50% of my base pay at 20 years. There are options on how to get the $30,000: one payment, two at 15,000, three at 10,000, four at 7,500, or five at 6,000.

I have done some research on the subject and everything thus far says taking the 30,000 is a bad idea, but I like to cover all bases before doing anything. Also right now I have about $125,000 in debt, but I make enough to still meet all my bills. What would be the better thing to do, take the bonus and pay off debt, or keep the retirement plan for 50%?

The answer…

Josh, I believe you’re referring to the military’s REDUX retirement system. Since I’m unfamiliar I included a few great articles from The Military Wallet in the Resources and References section below. Check them out.

In general, here are three important factors to consider before tapping into retirement to pay off debt:

  1. your goals
  2. the type of debt you have
  3. your debt-to-income ratio.

Retirement goals

Everyone has different retirement goals.

How old you are, how much you have saved, and whether or not you plan to retire at all are several criteria to help layout your goals.

I don’t plan to retire. My goal has always been to find my passionate life’s work and pursue it, in some manner, until I’m gone – so my income may be rolling in until I die.

If your plan is to work a career for so many years and retire to something else, your goals will be different because you plan to live off retirement savings.

Define your goals to best answer the question.

Type of debt you have

Everyone has different types and amounts of debt.

Josh has $125,000 but we’re not sure what type of debt that is.

If the debt is low interest rate mortgage or student loan debt, tapping into savings to pay it off may not be a great idea.

If it’s high interest credit card debt, the decision will probably be different.

Define the type and amount of each debt to best answer the question.

Your debt-to-income ratio

Commonly referred to as your “DTI,” your debt-to-income ratio is a personal finance benchmark that relates your monthly debt payments to your monthly gross income.

Everyone has a different debt-to-income ratio.

Josh mentioned making enough to meet his bills but didn’t specify how much he makes or if he has extra income at the end of each month.

If paying the minimum payments on your debts leaves you with little to no money at the end of each month, taking the bonus to kick-start better financial health may be a good idea.

If you have extra money after meeting your monthly budget, it may be best to leave savings alone and use the extra to speed debt repayment.

Define your DTI to best answer the question.

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References and Resouces

Traditional and Roth IRA Contribution Limits and Deadlines

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Continually updated contribution limits for Traditional IRA and Roth IRA including tax years 2008, 2009, 2010, and 2011.

After discovering your contribution limits and deadlines I recommend filing your taxes with TurboTax Online – that’s what I do and I’m a small business owner.

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Follow this link for information on SEP IRA contribution limits.

2011 IRA Contribution Limits

According to the IRS, maximum IRA contributions for 2010 are the same for both a Traditional IRA and Roth IRA.  You can also split your contributions among both Roth and Traditional, but your combined contribution amounts are subject to these same limits. The limits do not apply to rollover contributions.

Under 50 years old at the end of 2011:

  • Traditional IRA contribution limits = $5,000
  • Roth IRA contribution limits = $5,000
  • Combined IRA contribution limits = $5,000

Over 50 years old as the end of 2011:

  • Traditional IRA contribution limits = $6,000
  • Roth IRA contribution limits = $6,000
  • Combined IRA contribution limits = $6,000

The limits as they pertain to you are always the smaller of the numbers given or your taxable compensation.  In other words your IRA contribution limits will be the numbers given below unless your 2011 taxable compensation was less than the number given under each circumstance.

Modified AGI rules for 2011

The IRS also says that your IRA contribution limits may be reduced depending upon your modified adjusted gross income (modified AGI).

For 2011 Roth IRA contributions this MAGI phase out range is $110,000 – $125,000 for single filers and $173,000 – $183,000 for married filing jointly.  Basically if your income falls under these amounts your IRA contribution limits will be reduced accordingly.

For 2011 Traditional IRA contributions your MAGI affects your limits on tax deductibility according to you or your spouses participation in employer retirement plans.

  • If neither you nor your spouse participate in an employer retirement plan your contributions are fully tax deductible.
  • If you participate in an employer retirement plan the MAGI phase out range is $58,000 – $68,000 for single filers and $92,000 – $112,000 for married filing jointly.
  • If only your spouse is in an employer retirement plan the MAGI phase out range is $173,000 – $183,000 for married filing jointly.

2011 IRA Contribution Deadlines are April 17th, 2012.

I recommend filing your taxes with TurboTax Online and highly recommend using either Lending Club or Betterment to house your IRA.

2010 IRA Contribution Limits

According to the IRS, maximum IRA contributions for 2010 are the same for both a Traditional IRA and Roth IRA.  You can also split your contributions among both Roth and Traditional, but your combined contribution amounts are subject to these same limits. The limits do not apply to rollover contributions.

Under 50 years old at the end of 2010:

  • Traditional IRA contribution limits = $5,000
  • Roth IRA contribution limits = $5,000
  • Combined IRA contribution limits = $5,000

Over 50 years old as the end of 2010:

  • Traditional IRA contribution limits = $6,000
  • Roth IRA contribution limits = $6,000
  • Combined IRA contribution limits = $6,000

The limits as they pertain to you are always the smaller of the numbers given or your taxable compensation.  In other words your IRA contribution limits will be the numbers given below unless your 2010 taxable compensation was less than the number given under each circumstance.

Modified AGI rules for 2010

The IRS also says that your IRA contribution limits may be reduced depending upon your modified adjusted gross income (modified AGI).

For 2010 Roth IRA contributions this MAGI phase out range is $107,000 – $122,000 for single filers and $169,000 – $179,000 for married filing jointly.  Basically if your income falls under these amounts your IRA contribution limits will be reduced accordingly.

For 2010 Traditional IRA contributions your MAGI affects your limits on tax deductibility according to you or your spouses participation in employer retirement plans.

  • If neither you nor your spouse participate in an employer retirement plan your contributions are fully tax deductible.
  • If you participate in an employer retirement plan the MAGI phase out range is $56,000 – $66,000 for single filers and $90,000 – $110,000 for married filing jointly.
  • If only your spouse is in an employer retirement plan the MAGI phase out range is $169,000 – $179,000 for married filing jointly.

2010 IRA Contribution Deadlines are April 18th, 2011.

IRA Contribution Limits for 2009

According to the IRS, maximum IRA contributions for 2009 are the same for both a Traditional IRA and Roth IRA.  You can also split your contributions among both Roth and Traditional, but your combined contribution amounts are subject to these same limits. The limits do not apply to rollover contributions.

Under 50 years old at the end of 2009:

  • Traditional IRA contribution limits = $5,000
  • Roth IRA contribution limits = $5,000
  • Combined IRA contribution limits = $5,000

Over 50 years old as the end of 2009:

  • Traditional IRA contribution limits = $6,000
  • Roth IRA contribution limits = $6,000
  • Combined IRA contribution limits = $6,000

The limits as they pertain to you are always the smaller of the numbers given or your taxable compensation.  In other words your IRA contribution limits will be the numbers given below unless your 2009 taxable compensation was less than the number given under each circumstance.

Modified AGI rules for 2009

The IRS also says that your IRA contribution limits may be reduced depending upon your modified adjusted gross income (modified AGI).

For 2009 Roth IRA contributions this MAGI phase out range is $105,000 – $120,000 for single filers and $167,000 – $177,000 for married filing jointly.  Basically if your income falls under these amounts your IRA contribution limits will be reduced accordingly.

For 2009 Traditional IRA contributions your MAGI affects your limits on tax deductibility according to you or your spouses participation in employer retirement plans.

  • If neither you nor your spouse participate in an employer retirement plan your contributions are fully tax deductible.
  • If you participate in an employer retirement plan the MAGI phase out range is $56,000 – $66,000 for single filers and $89,000 – $109,000 for married filing jointly.
  • If only your spouse is in an employer retirement plan the MAGI phase out range is $167,000 – $177,000 for married filing jointly.

2009 IRA Contribution Deadlines are April 15th, 2010.

IRA Contribution Limits for 2008

According to the IRS, maximum IRA contributions for 2008 are the same for both a Traditional IRA and Roth IRA.  You can also split your contributions among both Roth and Traditional, but your combined contribution amounts are subject to these same limits. The limits do not apply to rollover contributions.

Under 50 years old at the end of 2008:

  • Traditional IRA contribution limits = $5,000
  • Roth IRA contribution limits = $5,000
  • Combined IRA contribution limits = $5,000

Over 50 years old as the end of 2008:

  • Traditional IRA contribution limits = $6,000
  • Roth IRA contribution limits = $6,000
  • Combined IRA contribution limits = $6,000

The limits as they pertain to you are always the smaller of the numbers given or your taxable compensation.  In other words your IRA contribution limits will be the numbers given below unless your 2008 taxable compensation was less than the number given under each circumstance.

Modified AGI rules for 2008

The IRS also says that your IRA contribution limits may be reduced depending upon your modified adjusted gross income (modified AGI).

For 2008 Roth IRA contributions this MAGI phase out range is $105,000 – $120,000 for single filers and $166,000 – $176,000 for married filing jointly.  Basically if your income falls under these amounts your IRA contribution limits will be reduced accordingly.

For 2008 Traditional IRA contributions your MAGI affects your limits on tax deductibility according to you or your spouses participation in employer retirement plans.

  • If neither you nor your spouse participate in an employer retirement plan your contributions are fully tax deductible.
  • If you participate in an employer retirement plan the MAGI phase out range is $55,000 – $65,000 for single filers and $89,000 – $109,000 for married filing jointly.
  • If only your spouse is in an employer retirement plan the MAGI phase out range is $166,000 – $176,000 for married filing jointly.

2008 IRA Contribution Deadlines are April 15th, 2009.

Traditional IRA and Roth IRA Deadlines

As I have touched on in previous articles, if you have not contributed to your 2009 IRA, no need to panic… the IRA deadline is not until tax day – but the sooner you contribute the sooner you can get your taxes done!  🙂

  • IRA deadline for 2008 contributions is April 15th, 2009.
  • IRA deadline for 2009 contributions is April 15th, 2010.
  • IRA deadline for 2010 contributions is April 18th, 2011.
  • IRA deadline for 2011 contributions is April 17th, 2012.

I recommend filing your taxes with TurboTax Online and highly recommend using either Lending Club or Betterment to house your IRA.

Note: I am not a tax professional. Consult IRS Publication 590 and/or your tax professional for details.

When Does Compound Interest Kick-in?

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The day we begin investing money into interest bearing accounts we begin to earn interest on that money.  But for most of us the interest amounts earned on our savings can be pretty minute for quite a few years.  Oftentimes piddly interest amounts earned can discourage investors and savers alike causing many to fore go saving altogether, opting instead to use their discretionary income on the here and now.

To help us avoid this huge mistake, let’s spend some time studying the meaning and payoff schedules of compound interest.

Kick-in = when we start seeing our yearly interest payments supersede our savings contributions themselves.

If we contribute to our savings regularly, when will compound interest finally “kick-in?”

Let’s take a look…

Compound interest explained

Compounding – The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.  Also known as “compound interest”.  source: Investopedia

Compound Interest – Interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan or debt. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount.  source: Investopedia

Example: We have an annual salary of $50,000/year and save 12% of our pay.  At the end of the year we have $6,000, which earns us a 7.5% return in our retirement account leaving us $6,450.  If we continue to invest this money we earn interest not only on our original $6,000 but also on the $450 gained in interest on the original principal.

Why we should care

It can work for us…

Through the rough numerical examples above we are able to see how compound interest can be a very powerful savings tool that stands to benefit us more the longer we employ it.  That is why you always hear people saying to invest as early in life as possible.  The sooner we get compound interest working in our favor, the sooner we can live employment optional (my term for working when you want.)

Or it can work against us…

Anyone who has a mortgage is all to familiar with what I am about to say.  Let’s say your purchase a home for $150,000 with $0 down and finance it for 30 years at 5%.  You will have monthly payments of $805.23, with the majority going toward interest all the way until year 16 when your principal payments will begin to be larger than your interest payments.  When it’s all said and done, you will pay $139,883.68 in interest and your $150,000 house will end up costing you $289,883.68.

When does it pay off?

If we continue to save regularly, when will the yearly interest on our savings begin to supersede our savings contributions themselves?

The answer to that question is always going to be relative to how much we are earning and how much we are saving, but should generally conform to the secret of two times pay.

The Secret of Two Times Pay is a concept I recently came across while reading Your Money Ratios.  Author Charles Ferrell says that, “our finances hit a tipping point at about two times pay.” Charles goes on to say, “After you have saved two times your pay, the earnings from your capital will generally add more to your total wealth than the amount you save each year.”

Let’s consider our example from above once more:

Let’s assume we have been saving for 10 years and have $100,000 saved in our retirement account, or twice our annual pay.  With our 7.5% return the earnings on our $100,000 will be $7,500 which now exceeds our annual savings amount of $6,000.  This year we increase our retirement savings by $13,500 and more than half of it came from earnings on our capital.

How long will it take?

That all depends on you!

Don’t forget about the ‘Rule of 72’

The ‘Rule of 72’ – is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.  source:  Investopedia

Example: a 10% investment will take 7.3 years to double ((1.10^7.3 = 2).

Set a goal to save twice your annual income so you can begin watching your money work harder for you than you do!  This is a goal that is attainable with just a few years of disciplined, consistent saving.  Let’s use this as further motivation to stay on track.

All I know is the sooner we get out of debt and get started investing, the sooner we will be able to watch our capital work for us instead of us working for our capital!