Should you save for retirement or get out of debt? It depends on your circumstances.
Money Girl answers a listener question and provides a five-step guide to help you prioritize your precious financial resources.
A single person with no dependents and plenty of job opportunities wouldn't require as much emergency cash.
Ideally, you should accumulate a minimum of three to six months’ worth of living expenses. Another good rule of thumb is to save at least 10% of your annual gross income. For instance, if you earn $50,000, make a goal to accumulate and maintain a $5,000 emergency fund.
A good rule of thumb is to save at least 10% of your annual gross income.
If you’re starting with zero savings, you could begin with a small goal, such as saving 1% or 2% of your income each year. Or you could start with a small target like $500 or $1,000 and increase it each year until you have a healthy cushion.
If you try to accomplish other financial goals before accumulating a cash reserve, you’re putting the cart before the horse. So, evaluate how much savings you have, how much you need, and create a plan to bridge the gap.
A common mistake to avoid is investing your emergency savings or thinking you could tap your retirement fund. Your emergency fund should be in a safe, high-yield, FDIC-insured savings account. Don’t worry if your savings earn little or no interest. The purpose is for your emergency money to be accessible and liquid in the short term. If you invest it, the value could shrink to nothing the moment you desperately need it.
Being financially responsible means that you’re prepared for a day when bad luck may strike. Think of an emergency fund as an investment in yourself that ensures future financial safety and happiness.
If you don’t have enough savings in the bank to handle an unexpected hardship, that’s your first financial task.
So, if you don’t have enough savings in the bank to handle an unexpected hardship, that’s your first financial task. If you struggle to save, automate the process by having a portion of your paycheck direct-deposited into a savings account. Or you could set up an automatic recurring transfer of funds from your checking account into savings.
2. Fill your insurance gaps
In addition to having an emergency fund, an essential part of being prepared for the unexpected is being adequately insured. Many people get into debt because they don’t have enough or any of the right kinds of insurance. These include a health plan, disability insurance, and a renter's or homeowners policy.
Without enough insurance, an accident, natural disaster, or lawsuit could jeopardize your financial security and happiness.
As you earn more and your net worth increases, you’ll have more income and assets to protect from unexpected events. Without enough insurance, an accident, natural disaster, or lawsuit could jeopardize your financial security and happiness.
If you think health insurance is too expensive, shop the federal or state marketplace, which offers coverage at a reduced price based on your income and family size.
As I mentioned, disability insurance is another important (yet often-overlooked) type of coverage that every earner should have. It replaces some amount of your income, such as 60% or 70%, if you’re unable to work due to a covered disability, illness, or accident. Health insurance only pays a portion of your medical bills. It doesn’t pay living expenses, such as housing or food, if you can’t work.
3. Address your dangerous debts
After accumulating some emergency savings and purchasing the right types of insurance, your next financial priority is to get rid of what I call dangerous debts. These might be tax liens, overdue child support, or accounts in collection. If you have any of these types of debt, you need to get caught up as quickly as possible.
Dangerous debts can destroy your financial health because they drain your resources and keep you from using your money to save or invest.
Dangerous debts also include high-interest credit accounts—such as payday loans, credit cards, and car loans—with rates in the double digits. These accounts can destroy your financial health because they drain your resources and keep you from using your money to save or invest.
In general, it’s best to tackle your highest-rate debt first because it costs you the most in interest. Don’t worry yet about paying off low-interest debts, like mortgages or student loans, ahead of schedule—they’re relatively inexpensive. Additionally, they come with built-in tax deductions, which further reduces their cost on an after-tax basis.
To learn advanced strategies to tackle debt quickly and in the right order, read or listen to Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, an Amazon #1 New Release.
4. Invest for retirement
After you’re prepared for the unexpected with savings and insurance, and dealt with any dangerous debts, it’s time to turn your attention to retirement. As I mentioned, this is a higher priority than paying off an inexpensive, low-rate debt, such as a mortgage or student loan, ahead of schedule.
The earlier you begin saving for retirement, the better. Not only does starting early give you more time to make contributions, but you leverage the power of compounding interest. Compounding is when your earnings earn their own earnings, and your account value can mushroom.
Let’s say you invest $500 a month over 20 years for a 10% average return—you’d have about $380,000. If you started five years earlier and invested that same amount for the same return over 25 years, you’d have over $665,000.
But if you invested for 30 years, you’d end up with an impressive nest egg that’s over $1.1 million! In other words, investing five years earlier can give you an additional $435,000! Getting started sooner, rather than later, can make the difference between scraping by or having a comfortable retirement.
If you have a retirement plan at work, such as a 401(k) or 403(b), that’s the first place your money should go. For 2019, you can contribute up to $19,000, or up to $25,000 if you’re age 50 or older.
Put your retirement ahead of creditors; otherwise, you risk starting too late and not having enough time to catch up.
If you don’t have a workplace plan, anyone with earned income can have an IRA. For 2019, you can contribute up to $6,000 or $7,000 if you’re age 50 or older. And if you’re self-employed, you have more retirement account options, including a SEP-IRA or a Solo 401(k). In general, you can even max out multiple retirement accounts in the same year.
A good rule of thumb is to always invest a minimum of 10% to 15% of your gross income for retirement. For instance, if you earn a $50,000, set aside no less than $5,000 per year. If you do that consistently over several decades, you can retire with at least a million dollars.
But if saving 10% seems out of reach, simply make sure you enroll in a retirement account and start making small contributions. Even investing $25 a month is better than nothing.
Until you’re regularly investing some amount for retirement (even if it’s small), don’t even think about paying off non-dangerous debt ahead of schedule. Put your retirement ahead of creditors; otherwise, you risk starting too late and not having enough time to catch up.
In the next step, I’ll help you figure out how much to allocate to both your debt and retirement.
5. Pay off debt by interest rate
Once you’re prepared for the unexpected and are consistently investing for retirement, it’s time to tackle your debt. But not all debt is created equal, so you need a strategy to choose the best accounts to eliminate first.
Your goal should be to figure out what’s more profitable: saving the interest you’re currently paying on debt or investing money with the expectation that it will grow. Ask yourself, which option will give me the highest return on my money?
Paying off debt gives you a straightforward, guaranteed return.
Paying off debt gives you a straightforward, guaranteed return. For instance, if you’re carrying debt on a credit card that charges 26% interest annually, paying it off is an immediate 26% return.
You’d be hard-pressed to find an investment that would pay you a 26% return after taxes. So, paying off a high-rate credit card debt is a much smarter financial move than investing.
But as I previously mentioned, you shouldn’t be in a rush to pay off debt with low rates, such as a 4% mortgage or a 5% student loan, ahead of schedule. These two types of debt also come with tax breaks that make them even less expensive on an after-tax basis.
In general, you’re better off investing money than using it to pay off a low-rate debt. You’ll earn more than you could save by eliminating the interest expense.
Additionally, you may have other financial dreams, such as buying a home or sending kids to college. Once you’re consistently setting aside money for retirement and eliminate expensive debt, you may choose to fund other goals instead of paying off inexpensive debt.
Should You Stop Saving for Retirement to Get Out of Debt?
Let’s get back to Heather’s question about whether she should stop making retirement contributions to get out of debt faster. I hope I’ve made the case that the answer is no.
Don’t put your creditors’ best interests ahead of your own.
Don’t put your creditors’ best interests ahead of your own. Not saving for retirement is just too risky.
When you have debt with double-digit interest rates—such as a 26% credit card or a 12% car loan—there's no debating that you should wipe it out as quickly as possible. Just tackle it while simultaneously saving for retirement.
But before you prepay a low-rate debt, especially one that comes with tax deductions, consider that saving for retirement is usually a smarter move over the long-term. Plus, prepaying a low-interest loan could leave you cash-poor in the event of an emergency.
The best choice for you depends on your risk tolerance and personal feelings about debt. Once you take care of yourself by building an emergency fund, having insurance, and investing for retirement, how you prioritize extra money is your call. Just make sure that how you spend money aligns with your values and always moves you closer to achieving your financial goals.
This post originally appeared on Quick and Dirty Tips and has been republished with permission.