Should I pay off debt or save for retirement?

This can feel like a tough question. And it comes in quite a few different flavors – should I save or pay off debt? should I invest while paying off debt? should I save for retirement while paying off debt? etc.

Because paying off debt and saving for retirement are to very important goals, but there is only so much income to meet both needs.

And each decision feels incredibly final. For investing in retirement:

  1. Once we make a contribution to our 401k that money is ‘metaphorically’ lost to us. We can’t withdraw it without paying a penalty for taking our own money nor without paying taxes on it (and who wants a higher tax bill) whereas if we pay off the debt and need the money back we can use the card again.
  2. It feels like we are giving away our money to someone even though in this case it’s our future self

For paying off debt:

  1. We believe it might be easier to save for retirement once we are debt-free
  2. We constantly hear how it’s bad, sinful, wrong or stupid to continue to have debt while investing.
  3. Depending on the debt, once it’s paid off that money is gone too – think your mortgage or your student loans. If you change your mind, don’t expect to get the money back

Now, these are all valid points.

You definitely can’t build wealth on a shaky foundation i.e. when debt is eating away at your income. And it’s also correct that when you’ve paid off your debts, then you free up more ‘disposable’ income so you can go gangbusters on your investments later on.

So I can totally see how sacrificing investing is very appealing.

But here’s the deal.

You Can’t Afford to Ignore Retirement

Sacrificing retirement savings to pay off debt can get us right back into debt when we retire.

Because you lose your most precious resource – time.

Every day you delay investing costs you money because how long you are invested in the market for is just as (if not more) important than how much you put in.

Don’t believe me? check out the graph below. Jack starts investing at 25 and continues investing $200 a month for 10 years, and then he stops investing. Jill, on the other hand, starts investing at $200 a month at 35 years old – right when Jack stops and continues to invest for 30 years.

When Jack and Jill both retire at 65, Jack would have contributed only $24,000, while Jill would have contributed over 3 times that at $72,000. She had to invest more and save for longer, and Jack still had more money for retirement than her. So you can’t afford to not invest at all while you are paying down debt – no matter how noble the cause.

So where does that leave us? What should we do? It’s frustrating to think about. And it can feel like they are both mutually exclusive but they are not.

Here’s an integrated plan of investing while paying off debt

This plan assumes you have some funds set aside in the event of an emergency or at least mild unplanned event and that your debt has bad terms or high-interest rates – think over 15% or higher where they need immediate attention.

Step 1: Contribute the minimum to your 401k to receive company match.

A company match is a part of your compensation and should not be left on the table. So whatever plan you decide to do it must include taking advantage of free money. And speaking of free money, not only does your 401k provide a vehicle to help you save, but it also allows you to basically get a double your contribution amount in your retirement savings without sacrificing more from your paycheck.

Not to mention lowering your taxable income. A huge plus if you are in a high-income tax bracket.

Step 2: Contribute the minimum to receive HSA incentive dollars from your company (if you have it)

If you have an HSA and your company offers you incentive dollars, then it’s free money. As I said before, any matching dollars your company provides you is a part of your compensation and you should definitely not leave that on the table. Unless you want to give them back their paycheck, then in which case, don’t contribute.

Step 3: That’s all for investing.

That’s it. You’re done with investing.

Walk away from the table.

Don’t contribute anything above that while you are focusing on your debt. Don’t invest separately in taxable investment accounts. Resist the urge to start building before you have a plan.

Step 4: Focus on your debt.

If you make the decision to get out of debt, then by George you better make it the forefront.

You need to be very focused during that time to try and knock out as much of your debt as possible in 2 years. Notice I did not say to pay off all your debt in 2 years, I said to knock off as much as you can in 2 years.

That’s because when debt is your main focus, you aren’t contributing as much as possible, or saving as much as possible because you need the extra dough.

But you don’t want to continue on the path of sacrificing all other goals, including your ability to invest for more than 2 – 5 years or worse even more years.

One to two years is fine, but anything above that is unsustainable and you lose too many years of contributing

 Step 5: Get back to your contributions

Once your debt is cleared or after two years of aggressive paying, if you still have some debt, then you want to get your debt interest rate lowered.

This will make your payments go farther (since you pay less interest) and then you want to start slowing down and start contributing to your 401k again. Every few months try and add back another 1% (or more ) if you can to ramp back up as much as you can and still pay above the minimum payments.

Of course, it would be great to keep going as aggressively with debt as possible, but again we can’t do the bare minimum for retirement for extended years.

Contributing only to the company match won’t be enough for most people to retire on so you want to get back to contributing as much as possible quickly.

Always be flexible.

We make plans, but life happens, so don’t make the previous guidelines a hard and fast rule.

If you’re making progress on the debt and the stock market is tanking and everything is selling low, then go ahead and slow down some on your debt repayment and contribute to your 401k above the match, or make taxable investments.  Because when markets are down you have the opportunity to invest when the market is low and over time you will be able to sell when things are high again.

That’s a great way to supercharge your retirement savings without having to contribute more. You don’t want to miss your chance to maximize your retirement returns by buying low and selling high.

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