9/14/2012 8:05 PM ET|
Should you pay debt or invest?
Paying down high-interest debt is important, but that doesn't mean you can afford to neglect your retirement savings.
A lot of advice about paying off debt encourages a laser-like focus. Debt is expensive, while investment returns are uncertain. Who wouldn't choose to pay off a credit card charging 22% instead of funding a retirement account that might return 8% (maybe, if you're lucky)?
So, case closed, right? Not so fast.
Too many people making the debt vs. investing analysis are missing the bigger picture. And if they knew exactly what they were missing, they would understand the correct answer is: Do both.
Here's why: Retirement is expensive, and it can last a long time. Most people will have to save a substantial portion of their earnings over their working lifetimes if they want to retire comfortably. If they don't take the opportunities they're given to invest for retirement, they quickly fall behind, never to catch up.
More specifically, here's what you lose when you don't invest for retirement:
A possible company match. Most companies that offer 401k plans also offer some kind of match -- typically half of what you contribute, up to 6% or so. That's free money, honey, and represents an instant 50% return. Even smaller matches can give your account a substantial boost.
A tax break. When you put a dollar into a retirement plan, you get to invest the whole dollar. If you want to put the same dollar toward your debt, however, you'll typically have only 85 cents to work with if you're in the 15% federal tax bracket -- and even less if you're in a higher bracket. Lower-income people could be giving up even more: a tax credit that can equal up to 50% of your contribution.
The power of compounding. It's been called the eighth wonder of the world, for good reason. It can make you rich if you understand how it works.
The best way to illustrate its power is through the example of twins Megan and Morgan. Megan invests $250 a month, or $3,000 a year, in an IRA starting at age 22. Morgan procrastinates. At age 32, Megan stops investing and Morgan starts, putting aside the same $3,000 a year and continuing for the next 30 years.
Overall, Morgan contributes a lot more to her retirement: $90,000, versus Megan's $30,000. But guess who has more money at age 62? It's Megan, the one who got the early start. Exactly how much more depends on the rate of return you use, but assuming a 7% return would leave Megan with $315,522 and Morgan with $283,382.
You may not be able to contribute $3,000 a year yet. You may not have a sister named Morgan. It doesn't matter. The point is that money contributed to your retirement accounts when you're young matters a lot more than money contributed later in life. If you put off investing for retirement, it will get harder and harder to catch up. Many people find they can't. Their expenses grow as they get older, and they can't reclaim the golden opportunity they had in their youth to assure their future comfort.
That doesn't mean it's hopeless if you've already reached midlife without much retirement savings. But you really need to start socking money away and not putting it off any longer, unless you can live on about $1,000 a month (which is the typical Social Security check).
Here's the thing: Saving for retirement is often a "use it or lose it" proposition. You can't get back the company matches or tax breaks you didn't use. You can't make up for lost opportunities to fund Roth IRAs, which probably should be called the ninth wonder of the world. (Roths don't offer an upfront tax deduction, but your contributions can be withdrawn tax-free anytime, and all your earnings are tax-free when withdrawn in retirement.) You certainly can't turn back the clock to get the returns you missed because you failed to make those contributions.
Will your investments show positive returns every year? Probably not. Some years, you'll lose money. But over time, a diversified portfolio of investments should earn the kind of returns you'll need to retire someday.
- Calculator: Do I have too much debt?
Does that mean you can ignore your debts? Hardly. What you need is a smart debt repayment plan that focuses on paying off your most toxic debt, such as credit cards, while you also save for retirement. You don't have to be in a rush to pay off low-rate, potentially tax-deductible debts such as mortgages and federal student loans. Save prepaying those obligations until all your other debts are paid off and you're on track for retirement.
What if you just can't do it? What if you can pay only the minimums on your debt, or less, if you try to save for retirement? Then you're in a deeper hole than you may understand. If you can't cut your expenses or earn more money to free up the necessary funds, then it's time to make two appointments: one with a legitimate credit counselor and another with an experienced bankruptcy attorney, to see what your options might be.
Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.
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We all know the politicians and most of the big boys on wall street suck, and are self centered SOB's - so no solution will be forthcoming from there. Even if regulations are passed they won't be enforced anyhow. It is all a bunch of hooey. Most of us don't have to worry about retirement as much as we think. Most of us will be dead by age 70. All the propaganda about living to 90 or 100 is just that "propaganda" - to push us to give wall street more of our money to play with. Yes a few lucky souls are living a long time but that has always been the case. Percentage wise more people are living longer but those percentages don't translate into a high number. In the past if 1000 people lived to 100 that was great. If it doubled to 2000 that is a 100% increase which sounds impressive but that is still only 2000 people. Most people based on my observation are still dropping dead between 50 and 70. Most that make it past that don't have much quality of life anyhow, and a lot are kept alive on feeding tubes and 20+ medications per day. People want to believe so bad in this supposed longer life span that they refuse to pull the curtain back and look at the sad truth. Wall street preys on our fears about life and death and they say what ever they need to say to separate us from our money.
Who are these clowns??? Do they get paid extra for giving extra bad advice?
Except for getting the employer match, Weston is wrong on just about everything she wrote. (I presume everyone understands the benefits of saving early and often,)
She talks about compound interest on investments. Yeah, duh. But she completely ignores that debt interest compounds, too. Compounding 22% against you is a whole lot worse than compounding 8% for you. Where did she go to middle-school? Didn't they teach anything? Compound the difference (14%) and you double your debt every 5 years. Anybody think that's a good idea?
As for investing before tax dollars in IRAs, 401ks, etc., yeah, it's true. But it's also true that when you take out the money, you pay ordinary income tax on it. Run the numbers and you'll discover that you're better off in the long run investing (buy and hold - generate long-term capital gains and dividend income) OUTSIDE your tax-deferred accounts. The only exception comes if your tax rates are lower when you take the money out. Does anyone think that's going to happen? (This advice does not apply to ROTH IRAs - they're the best deal you'll ever get from the government!)
By the way, look at the tax code now. If you take money out of your IRA, it's ordinary income. When you retire, that's going to cause you to pay more tax on your SS and a higher premium for Medicare. If you invest outside of IRAs, etc., your income will appear to be much smaller and you'll get a better tax deal.
HaHaHaHaHaHaHaHa!!!!!! Best laugh I have had in a while. Learned all this in College did we? Text book says 7% compounding, but, but, but isn't that real life??? My college professor said it was!! No Obamabernankenway! Today if you get .7% interest you are lucky. Did you catch that little tiny decimal point before the seven?? Compound that and see where you end up!! Pay off the 22% interest credit cards and only use them when you can pay off the balance every month. Reality check time. Today it really does not matter what you do anymore. With the government spending trillions more than what is comming in and the federal reserve's QE3 printing presses running at 500% capacity for the forseeable future, our credit rating as a country being downgraded, everyone's nest eggs will be worthless soon. Buy a farm at least you can grow something and eat it.
This is a no brainer.
Pay off your debt as quickly as possible.
How do you get the 7% returns she speaks of when your government does nothing but passes crazy legislation (i.e. everybody deserves a house whether they can afford it or not), and constantly prints money to make all of our money worth less while asking taxpayers to bail out bankrupt companies that they have supported (Solyndra).
Any way you look at the investment (asset) side of your personal balance sheet, you are leveraging those investments by having debt on the liability side. That inevitably makes your net worth (equity) balance riskier and more volatile. I say never borrow money to invest. These days, just when you think you have you're whole strategy figured out, along comes the Fed or the government with another major policy change that can wipe out your strategy and your wealth. There's no winning it, because, the people doing it are targeting your wealth.
Excessive debt is the number one cause of personal financial crisis and the economic crisis we are all facing right now. It’s pervasive from the individual, to corporations, to trillions in sovereign debt that can never be paid off.
Instead of debt vs. invest, how about don’t borrow and save? I think that’s a better way to start.
Funny. The example of Morgan and Megan conveniently addresses only one side of the issue, and conveniently assumes a real return on investment. What if Megan, while socking away that $3K per year is simultaneously NOT paying down her debt as fast as she can, thus incurring interest on her outstanding debt that triples the amount of the return she is making on her investment, rendering her "savings" illusory; while Morgan not only gets all paid off but then has the cash flow to really enjoy life while she's young enough to enjoy it? Furthermore, "the power of compounding" only works when return on investment is positive. The way the game is rigged these days -- dominated by greedy and ethically-challenged members of the C-suite, enabling and lying internal and external accountants, unmotivated and underresourced regulators and sycophantic "analysts" -- a positive return is more like a pipe dream. Talk to some folks who followed Liz's advice before 2008 and see where they stood in 2009. And a company match? Perhaps Liz missed the memo that a lot of companies have ended that nice little perk as currently unaffordable.
Living debt free is the way to go, and paying down early whatever existing debt you have is the only sure-thing investment in today's environment.
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