The answers to the questions you have always had about your personal finances.

 

We will frequently address a personal finance, tax, or investment topic that personally affects you and your overall financial well-being.  These articles will be laid out in a way that everybody can understand and apply to their own real life finances.  We at Bergerson Tax Services, Inc can help you with all of your personal finance and tax related needs. Please fell free to contact us anytime. This month’s topic is

Should I Pay off My Debt Or Should I Invest For My Retirement?

 

By Jeff Bergerson, Bergerson Tax Services, Inc

In a perfect world you would be able to pay off all of your debt and also invest for your retirement.  Unfortunately, like most of us you probably do not have enough money to pay off all of your debt and invest for your retirement at the same time.  So what is the most financially savvy strategy to help you pay off your debt and fully fund a retirement account? Should you pay off all your debt before contributing to a retirement account; or should you keep certain debt and contribute to your retirement account.  In this article I will address the different types of debt that you might have, which debt is the best and worst to keep, and walk you through an illustration.

First of all, lets address the type of debt that you might currently have: Home mortgage, student loan, car loan, and credit card debt.  As I wrote in January’s article, To Pay Off My Home or Not to Pay of My Home, That is the Question, a home mortgage can be considered reasonably good debt to maintain.  Interest rates on home mortgages are generally lower than car loans or credit cards, plus the interest you pay is tax deductible. For example, if you have a interest rate of 6% on your mortgage and are in the 35% tax bracket, the after tax cost of your loan is only 3.9%.  Student loan interest is very similar in that the interest rates are reasonably low and the interest is tax deductible.  Up to $2,500 of student loan interest is deductible as long as your modified adjusted gross income is below $70,000 for single filers and under $140,000 for married filers.

Car loans are a different story; depending on the terms of your car loan your interest rate may or may not be as low as your home mortgage or your student loan, but the interest you pay on it is not tax deductible.  Finally, the worst kind of debt that you can have is credit card debt.  The national average interest rate on credit cards is a staggering 15%, plus the interest you pay is not tax deductible.

When determining what debt to pay off first, it is clear that credit card debt and possibly car loans need to be paid off before your home mortgage and any student loans. The question of whether to even try to pay off your home mortgage or keep it is answered in January’s issue, To Pay Off My Home or Not to Pay of My Home, that is the Question.

It has been determined that credit card debt is the first debt that you should attempt to pay off, but what about investing for retirement? Should you pay off your credit card first, and then save for retirement, or should you just pay the minimum on your credit card and invest the rest into your retirement account?

Lets look at an example to help you decide.

Lets say you have a $5,000 credit card balance of which the interest rate is 14%.  At the same time your employer has a 401K plan and offers a 50% match (50 cents per every dollar you contribute) up to 6% of your salary.  At first glance it looks like a no-brainer, 50% vs.14% returns.  But consider the fact that the 50% match is a one-time gift while the 14% compounds yearly and eventually will overtake the 50%.  Now lets say you have $250 every month of which you have to pay your minimum credit card payment of $125, so you have $125 to either put toward the balance of your credit card or invest in your 401K.

Example 1.  You pay just the minimum of $125 and invest the $125 (which is actually $174 because it will be contributed pre-tax) every month.  You will need 55 months to wipe out your credit card debt.  During that time if you earn 8% in your 401K and receive a 50% match you will accumulate $17,271 in your 401K.

Example 2.  You choose to put the entire $250 toward your credit card debt and hold off entirely on contributing to your 401K.  You will pay off your credit card in 23 months.  At that point you can begin contributing all $250 to your 401K.  By the end of 55 months you would have $18,515 in your 401K plan.

By focusing on paying off your credit card completely and then funding your 401K rather than splitting your money between the two you will have $18,515 rather than $17,271 over that 55- month period. You can see that paying off your credit card completely before funding your retirement plan is a more effective strategy.

There are a couple caveats to the idea that paying off your credit card will produce more money in your pocket overall.  First, if you just have a small amount of credit card debt and would be able to pay off that debt in under a year’s time, go ahead and fund your retirement account and take advantage of that employer match.  In instances where you do not have any credit card debt I would always advise to contribute the maximum amount to your 401K up to your company match, its free money!  The other time where I would advise to contribute to your retirement account before paying off your credit card debt completely is if you do not contribute to your 401K at first it meant you never ended up doing it.  In this case I would say start contributing and get the ball rolling and then pay off your credit card.

Ideally the best financial strategy for most people who have credit card debt is to focus on paying off your entire credit card balance first before you begin investing into your retirement account. Once you pay off your credit card balance, begin investing into your retirement account.

Now that we have determined paying off your entire credit card balance is the most financially savvy strategy, I will give you a couple of strategies to help you pay off your credit card debt in the most effective way.

If you have more than one credit card and cannot pay them all off, the best bet is to try to consolidate all of your cards into the one that offers the lowest rate.  Most credit card companies make offers of lower interest rates, called balance transfer credit cards, in an attempt to attract you to consolidate your debt with their company.  Be careful, as sometimes there is small print that can boost up your rate after a certain period of time.  Read all the small print and research the credit cards thoroughly before making your decision where to transfer your debt.

If you own a home and have built up equity, it would be a good idea to take out a home equity loan to pay off your credit card debt.  You will get a much better interest rate and the interest you pay on a home equity loan is tax deductible.  Whichever route you choose the most important thing to do is pay off your credit card and the sooner you begin, the better.

Jeff Bergerson founded Bergerson Tax Services, Inc (BTS) eight years ago and pilots a rapidly growing practice in St. Paul, Minnesota. Jeff has written many articles offering tax related strategies, financial strategies, and business guidance. Bergerson Tax Services, Inc. provides individuals and small business tax preparation services, small business consulting, and tax planning.  He can be reached on the web at http://www.bergersontax.com/ or by email at info@bergersontax.com.