Striking the Right Balance: Managing Debt While Saving for Retirement

It's a catch-22: You feel that you should focus on paying down debt, but you also want to save for retirement. It may be comforting to know you're not alone.

According to an Employee Benefit Research Institute survey, 18% of today's workers describe their debt level as a major problem, while 41% say it's a minor problem. And workers who say that debt is a problem are also more likely to feel stressed about their retirement savings prospects.¹ Perhaps it's no surprise, then, that the largest proportion (21%) of those who have taken a loan from their employer-sponsored retirement plans have done so to pay off debt.²Borrowing from your plan can have negative consequences on your retirement preparedness down the road. Loan limits and other restrictions generally apply as well.

The key in managing both debt repayment and retirement savings is to understand a few basic financial concepts that will help you develop a strategy to tackle both. Of course, this discussion presumes that one is attempting to avoid taking on “bad debt” going forward.

Compare potential after-tax rate of return with after-tax interest rate on debt

The general mantra of paying down debt aggressively or structuring debt to minimize the amount of interest paid is arguably too simplistic. One alternative approach to decide whether to pay off debt or to make investments is to consider whether you could earn a higher rate of return (after accounting for taxes) on your investments than the interest rate (after-tax) you pay on the debt. For example, say you have a credit card with a $10,000 balance that carries an interest rate of 18%. By paying off that balance, you're effectively getting an 18% return on your money. That means your investments would generally need to earn a consistent, after-tax return greater than 18% to make saving for retirement preferable to paying off that debt. That's a tall order for even the most savvy professional investors.

And bear in mind that all investing involves risk; investment returns are anything but guaranteed. In general, the higher the rate of return, the greater the risk. If you make investments rather than pay off debt and your investments incur losses, you may still have debts to pay, but you won't have had the benefit of any gains. By contrast, the return that comes from eliminating high-interest-rate debt is a sure thing.

As you evaluate your investments, reviewing the amount of your emergency fund or cash savings is also wise. If you have excess cash, you may want to opt to pay down high interest debt. However, merely because you have excess cash does not necessarily suggest using the excess cash to pay down all debt. Perhaps the excess cash is better used for long-term retirement planning. If you do not have an adequate emergency fund or just the right amount, you will need to weigh the benefits of paying down debt.

Are you eligible for an employer match and are you taking advantage of other company benefits?

If you have the opportunity to save for retirement via an employer-sponsored plan that matches a portion of your contributions, the debt-versus-savings decision can become even more complicated.

Let's say your company matches 50% of your contributions up to 6% of your salary. This means you're essentially earning a 50% return on that portion of your retirement account contributions. That's why it may make sense to save at least enough to get any employer match before focusing on debt.

And don't forget the potential tax benefits of retirement plan contributions. If you contribute pre-tax dollars to your plan account, you're immediately deferring anywhere from 10% to 39.6% in taxes, depending on your federal tax rate. If you're making after-tax Roth contributions, you're creating a source of tax-free retirement income.³

Your company may offer other benefits such as a stock purchase plan or health savings account that you may be more valuable to you than paying off certain debt. Understanding the details of these plans along with your cash flow and income tax situation could help you make an informed decision.

Consider the types of debt

Your decision can also be influenced by the type of debt you have. The interest rate, whether the rate is variable or fixed and the impact of the economy on this factor, and the tax deductibility of the debt should all be considered. For example, if you itemize deductions on your federal tax return, the interest you pay on a mortgage is generally deductible — so even if you could pay off your mortgage, you may not want to. Let's say you're paying 6% on your mortgage and 18% on your credit card debt, and your employer matches 50% of your retirement account contributions. You might consider directing some of your available resources to paying off the credit card debt and some toward your retirement account in order to get the full company match, while continuing to pay the mortgage to receive the tax deduction for the interest.

Note, however, that the income tax impact may not be as cut and dry as one may initially think. Understanding what interest is deductible “above the line” versus itemized deduction versus business debt is critical as well as various thresholds and phaseouts that may apply. As your income will vary over the years, it is important to take a multi-year view of your income tax situation to elect the optimal decision.

Other considerations

There's another good reason to explore ways to address both debt repayment and retirement savings at once. Time is your best ally when saving for retirement. If you say to yourself, "I'll wait to start saving until my debts are completely paid off," you run the risk that you'll never get to that point, because your good intentions about paying off your debt may falter. Postponing saving also reduces the number of years you have left to save for retirement.

It might also be easier to address both goals if you can cut your interest payments by refinancing debt. For example, you might be able to consolidate multiple credit card payments by refinancing your home or obtaining a home equity loan to pay this debt off. Of course, the cost of any additional refinancing should be considered.

Bear in mind that even if you decide to focus on retirement savings, you should make sure that you're able to make at least the minimum monthly payments on your debt. Failure to do so can result in penalties and increased interest rates, which would defeat the overall purpose of your debt repayment/ and retirement savings strategy.

As many individuals approach retirement, they often have the goal of paying down their mortgage. While this is often an attractive and reasonable goal, the arbitrage on the investments and debt may be lost. Moreover, paying down debt could erase some valuable tax planning opportunities in the years immediately after retirement. However, we recognize the psychological factor at plan – many people just feel better knowing the debt is paid down.

Thus, it is important to review the details and structure of your debt, your cash flow, your income tax situation, and your long-term goals in creating a roadmap for both managing your debt and providing a secure retirement.

¹Employee Benefit Research Institute, 2017 Retirement Confidence Survey.

²Employee Benefit Research Institute, 2016 Retirement Confidence Survey

³Distributions from pre-tax accounts will be taxed at ordinary income tax rates. Early distributions from pre-tax accounts and nonqualified distributions of earnings from Roth accounts will be subject to ordinary income taxes and a 10% penalty tax, unless an exception applies. Employer contributions will always be placed in a pre-tax account, regardless of whether they match pre-tax or Roth employee contributions.