This question has plagued financial planners for years. Should you pay off debt, or should they start a retirement account first? This assumes that the same amount of money is involved in each transaction. We will use $5,000 for our examples. Below we will take a look at the pros and cons of each option, and give our opinion.
Paying Off Debt First
Paying off debt is a great way to use a lump sum of money. Being in debt can be burdensome to the individual in debt, and feeling like you are never going to get out can be awful. If you do not have a lump sum, you may want to consider a debt management plan to help you. But, if you were going to use a lump sum of money to pay off debt, here is what it would get you.
Pros: Peace of mind, lower payments or elimination of payments if the debt is paid off, ownership if the debt is backed by something (i.e. a car loan).
Cons: You tie up your money into whatever your debt is.
Start a Retirement Account
Starting a retirement account is a great way to save for the future. Plus, since we’re talking about a $5,000 investment, that happens to be exactly how much the limit is for contributions to an IRA. Now, Congress has raised the limit, and you can invest up to $5,500 in 2013 and beyond in a IRA or $6,500 per year if you are over the age of 50. IRA rates are great when you pick good mutual funds to invest in. There are a lot of different types of retirement accounts available, but we are going to focus on opening a Roth IRA.
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Pros: Saving for the future, money grows tax free, can withdraw contributions tax free any time.
Cons: Can’t withdraw earnings tax or penalty free until retirement age.
The Trade Off
As you can see, both options don’t have too many cons. However, when making this decision, you should weigh the following: which will earn me a better return on my money?
If your debt has a high interest rate such as 19.99%, for example, it is highly unlikely that you will earn that return in a retirement account. So, paying off your debt could be a great use of your excess funds.
However, if your debt is at really low interest rates, say a 4% student loan, which you also can write off on your taxes (making the effective rate around 3%), a retirement account where you can earn 8% may be a better option.