Q: I know saving is important but I have too much debt. Because the interest rates on my debt are higher than I’ll ever get in a savings account (and I don’t feel ready to use a retirement account), I’m focusing on paying off debt for now. Is this the correct approach to take?
A: The dilemma of whether to pay off debt or to build up savings is a common one, and for good reason: there is no solution that fits everyone.
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For many people, debt can be such an enormous mental burden that it demands the bulk of their attention, and thus their financial resources. There’s also the motivational factor: it’s easier to overcome debt when you see your debt balances falling.
However, the psychological angle isn’t necessarily the best approach from a financial perspective.
It is understandable to pit the high interest rates of credit card debt and other loans against the dismal savings rates in today’s economic environment. In-the-face credit card debt at a 20% interest rate, or even a student loan at a 6.8% rate, you’re losing much more than the interest income provided by savings accounts and certificates of deposit. (Currently, the top savings rate is 1.00% APY and the best 5-year CD rate is 1.85% APY.)
But when it comes to tax-advantaged retirement accounts, you could be missing out on a large amount of potential future savings.
Firstly, if you are eligible for your company’s 401(k) plan and the company offers a contribution match, you are already missing out on “free money” if you don’t contribute enough to maximize the match.
For example, if you have a $40,000 salary and your company offers a 401(k) match of up to 5%, your contribution of $2,000 means a total of $4,000 for your 401(k) plan. No other “investment” can do that for your finances.
Then, by not contributing to any retirement account, you’re sacrificing years of tax-deferred retirement savings. If you don’t contribute to a retirement account for any particular year, you cannot go back and contribute for that year.
In 2012, you could have contributed a maximum of $5,000 to an IRA. Assuming an average 5% annual return, that $5,000 becomes $22,339 in 30 years. If you didn’t make that contribution, that tax-deferred growth is gone forever.
For those who can handle the psychological weight of debt, I’d suggest that focus be placed on maximizing the 401(k) match first. Then, you should make the effort to tackle high interest debt. Afterward, it is important to begin making contributions to an IRA (or additional contributions to an employer-sponsored retirement plan) alongside regular payments toward low interest debt.
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