Which Is First: Paying Off Your Debt Or Investing For Retirement?

by Guest Contributor

Should you invest or pay off debt?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.

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Guest Contributor has written 240 articles on Money Q&A. Learn more about Money Q&A on Twitter @MoneyQandA and @HankColeman.


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{ 12 comments… read them below or add one }

WorkSaveLive

This is certainly a great topic that comes with varying opinions. Instead of arguing I simply like to state my thoughts:

I believe you should only save for retirement (while still in debt) if there is a company match. 50% or 100% GUARANTEED return is better than paying off a 4% student loan. However, if you don’t have a match then I’d MUCH rather go with the GUARANTEE of paying off a 4% debt as opposed to HOPING I earn more in my investments.

With that said, how long you’re going to be in debt is also a factor. If it’s only 1-2 years then it’s not a big deal. But if you’re going to delay retirement savings for 5 years then that is a bit of an issue.

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Jai Catalano

I always say think of self first. I know that might be the reason one goes into debt there are ways to pay off debt. There aren’t ways to save for retirement if you let days pass by without doing so. I blinked and now I am — years old. I say retirement first…

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Kurt @ Money Counselor

I think the best answer to the pay off debt/contribute to retirement account dilemma depends on individual circumstances, but I agree with WorkSaveLive: It’s useful to look at paying off debt as making an investment with a guaranteed pre-tax return equal to the debt’s interest rate. It’s that ‘guarantee’ part that I personally find enticing. Even if the debt’s rate is only 5%, in today’s environment, I’d find that a rather appealing guaranteed rate of return!

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Modest Money

As others have said, I agree with paying off the debt first, unless it’s at a very low interest rate. The problem with that though is that it an really stretch out the time it takes to pay off that debt, which can lead to additional stress. For example, I have the remainder of a car loan on a 0% balance transfer. Obviously that gives me very little incentive to pay that off right away. So I instead put extra money into my retirement savings. It would be so nice to have that debt out of the way though.

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Doug P.

“Cons: Can’t withdraw earnings tax or penalty free until retirement age”

Correct me if I am wrong as I am not a financial planner. However, I believe that if you have $5,000 (example in article), then you have likely already earned it and paid taxes on it. In which case you could put it into a Roth IRA. In which case I believe (again, please correct me if I am wrong) that you can withdraw your contributions, but not earnings, from a Roth after 5 years.

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Hank Coleman

Yes, you can withdraw your contributions from a Roth IRA without penalty, not your earnings. The quote you used clearly talks about earnings.

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BeatingTheIndex

Pay the debt first if you thin k you can get 8% in ROI. In these markets there are no guarantees, just look at return for the last decade.

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SB @ One Cent At A Time

oh the age old question. I have no clear answer. I will do what best suited to me.

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Chique Weiz

This is very timely as I’m into deciding on opening an account or paying my debts. Well, after reading your post, i pondered, weighed both sides and I have now my decision.

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MoneySmartGuides

I think that first, you should save in your retirement account up to the match. After that, you need to decide what will make you feel the best: getting out of debt or investing your money. If your debts are over 6%, I’d say pay them off first. Under 6%, save and take your time paying off the debt. But if you are uncomfortable with carrying debt, then definitely make it a priority to pay it off.

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Sean @ One Smart Dollar

I have to go with paying off debt. On average your retirement account will earn you 8-10% interest while you could be paying 10-20% interest on debt.

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Dividend Diplomats

I think the key here is the interest rate on your debt. If your interest rate is high, absolutely pay off your debt so you aren’t throwing away free capital just to cover interest. However, if the interest rate is lower (I.e. car loan with great credit), I think you can afford to use your extra capital to invest in a dividend stock with a Yield greater than your interest rate. However, as others have said, it really depends on your situation.

Great post and a very relevant topic for almost everyone!

Bert, one of the Dividend Diplomats

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