Wow … what a loaded question! We always hear how crucial it is to get rid of toxic debt, especially credit cards with double digit interest rates. Therefore, people generally assume that paying off debt rather than investing for retirement is the correct answer. In my opinion, this is not really an either/or proposition. The best approach? Do both!
One of my favorite financial gurus is Liz Weston, a regular blogger for the personal finance section of MSN’s Money website. She often tackles difficult topics, and makes them easy to understand. Although this particular article received a lot of negative feedback, I truly believe that Weston is right.
Where you need to be:
Before getting into why it is important to both save for retirement and pay down debt, we have to start from a common point. To be able to move forward financially, it is essential that you are: 1) using a budget to control your spending and 2) have extra income for both debt repayment and your future retirement.
If you are spending more than you earn each month (or have no idea how much you spend), it is time to deal with the basics. This means learning to live within your means.
The brutal truth is if you don’t control your spending, you will likely continue to abuse credit, and never have money tucked away for emergencies or retirement.
To learn how to live within a budget and spend less than you earn (yes, you read that correctly), look over the many posts on our blog for some great information and steps to get you moving in the right direction (think “budgeting” and “saving.”) One in particular of mine is Budgeting Basics.
Saving for retirement:
Getting back to Westin’s article, she points out that retirement can be expensive and lengthy, especially since people are living longer these days. If your employer offers a retirement plan, and you don’t participate, you lose out in several ways.
- A match from your employer: Most employers will match a percentage of the contribution you make each month. This is free retirement money for you! Over time, even a small match will add up and make a difference. So, talk with your Human Resources Department to find out how your company retirement plan works and how much you must contribute to get an employer match.
- A reduction of taxable income: Your retirement contributions are withheld on a pre-tax basis. This means you pay less in income taxes overall because your taxable gross income will be less. If you feel you can’t squeeze out another dollar from your paychecks, talk with your payroll department to see what difference a small contribution to your retirement plan (2% – 4%) will make on your paychecks.
- The power of compounding: Westin calls this the “eighth wonder of the world.” She uses an example of twin sisters Megan and Morgan. At age 22, Megan begins investing $250 a month (or $3000 a year) into an IRA (individual retirement account). She continues to do so for the next 10 years. Meanwhile, Morgan invests nothing until age 32 when Megan stops all contributions. Just like Megan, Morgan invests $250 a month. But she does so for the next 30 years, not just 10.
Overall, Morgan contributes $90,000 to her IRA while Megan only contributes $30,000. Yet, at age 62, the value of Megan’s IRA would be about $315,000 while Morgan’s will be $283,000. This assumes a 7% annual rate of return. The main point here is that due to the power of compounding, money contributed younger in life makes more difference than money contributed later. Of course, your retirement account will have its ups and downs. But over time, if you are well diversified, your contributions will grow.
- There is always hope: Don’t give up if you are now middle-aged and haven’t started a retirement fund or you can’t afford to contribute $250 a month. There is no time like the present to begin retirement savings. Acting now can ensure you will have enough cash (or at least more cash) to live on when you retire. If you never get started, Westin points out the average Social Security check is around $1000 a month. Will you really be able to live on that?
Paying down debt:
- The “debt snowball” method: Make a list of your debt balances and pay off the smallest debt first. You pay as much money on the smallest debt as you can but also make the minimum payments on the rest. When the first debt is paid, you use that payment plus the minimum to get rid of the next smallest debt. And so forth and so on. The idea is that the emotional boost from ticking off smaller debts will keep you motivated to pay off everything.
- The “debt avalanche” method: This process is basically the same as the debt snowball method. But, rather than starting with your smallest debt, you tackle the debts in order of the highest interest rates. This method is superior in that you will pay less interest overall, but it may take longer to pay off each debt.
- Credit Counseling: If you are struggling with your debt, contact LSS Financial Counseling for a free and confidential appointment with a certified Financial Counselor. The counselor will review your overall financial picture and identify realistic options to conquer your debt. So, what have you got to lose? Take action today and call 1-888-577-227 to schedule an appointment and start building a brighter financial future!
Author Barbara Miller is a Certified Financial Counselor with LSS and she specializes in Bankruptcy Counseling/Education and Student Loans.