There are many aspects of financial planning to consider when deciding whether to pay down debt or save for retirement. We all know that both are important, but how do you know which one you should be focusing on? Guest blogger Nichole Coyle, Certified Financial Planner™, discusses what factors you consider.
Emergency Funds Come First
First, before you start allocating extra money to debt and retirement, your number one priority should always be to have a well-funded emergency account. It won’t matter how quickly you are paying down your debts or how much money you have saved for retirement if an emergency pops up and you have no cash to cover it.
Once you have your emergency fund covered, focus on paying off your debts AND saving for retirement. I generally advise not to solely focus on just one area. If you focus all of your resources on paying off debt, you may miss out on years of compounding interest in your retirement account and need to save a much larger amount later to make up for it. Conversely, if you focus solely on your retirement savings, only paying the minimums on your debts, you will not only end up paying exponentially more in interest over time, but you will also be paying on those debts for many, many years.
The Interest Rate on Your Debts
Not all debts are created equal. While it’s important to pay off debts with high interest rates, like those on many credit cards, some lower interest debts like a mortgage or student loans may not need to be paid down as quickly. With these types of loans, you can give yourself some space and allocate a little more for retirement instead. Conversely, if you do have high interest rates on some or all of your debts, you’ll most likely want to allocate more towards paying down those high-interest debts and less towards retirement savings in the beginning.
How Old You Are
If you are in your 20s or 30s and have a large amount of high interest debt it probably makes sense to focus mainly on paying down those debts, while still contributing something to your retirement account. Because you still have time to make up your retirement savings (and because you listened to this sage advice), still making contributions to save for retirement during this time will allow you to benefit from compound interest. However, as a 50-60 year old in the same situation, it may make more sense to focus equally on both areas, or even prioritize retirement savings in order to make up for lost time.
Save SOMETHING for Retirement
If you haven’t started to save for retirement in any way, regardless of your age, you should make that your number one priority. Even a small contribution will make a difference and over time you can increase those contributions, all while you benefit from the power of compounding interest. The sooner you start, the more time you allow compounding interest to work in your favor.
Does Your Employer Match Retirement Contributions?
If your employee has a 401K match, and you choose not to take part, you are leaving free money on the table! Not taking advantage of a 401K match is generally considered one of the biggest financial planning mistakes you can make. If your employer offers to match 3% of your contributions, contribute 3%. If your employer offers to match 5% of your contributions, contribute 5%. With a traditional 401k, your contributions are PRE-TAX, which means your $50 contribution may only look like $40 missing from your paycheck. (Keep in mind that the exact amount will depend on your withholdings and tax bracket).
Roth 401K match
Some employers may offer a Roth 401k option. These contributions are POST-TAX which means your $50 contribution looks like $50 missing from your paycheck. There are advantages and disadvantages to both. I suggest speaking with a Financial Planner, like myself, to help you decide which is best for you. Regardless which option you utilize, make sure you maximize your contribution to get the FREE MONEY from your employer’s match.
The Road to Financial Independence
Paying off debt is critical to your financial independence. But along with paying your creditors, it’s important to pay yourself by saving for retirement. This approach makes sense for two reasons. First, if you wait until your debts are paid off completely, you may never begin saving. And the later you begin saving, the less time your money can benefit from the power of compounded earnings over time. Second, seeing your savings accumulate provides the emotional and psychological boost many people need to keep moving forward.
Ultimately, I suggest meeting with a Financial Planner who can look at your entire financial picture. Together you decide how much to allocate towards each goal. As always, I am available to answer questions and to discuss your unique situation. Please don’t hesitate to contact me.
Nichole M. Coyle
CERTIFIED FINANCIAL PLANNER™
20333 Emerald Pkwy
Cleveland, OH 44135
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