Should You Pay Down Debt Or Save For Retirement?

Many of my clients struggle with deciding whether to pay down their debt or save for retirement.  Usually, a starting point for the analysis is to look at whether you can earn a higher after-tax rate of return by investing as opposed to  the after-tax rate that you pay on the debt you are carrying. For example, if you have a credit card with a $10,000 balance, and the non deductible interest rate is 18%, you are effectively getting an 18% return by eliminating this debt.  The return that comes from eliminating high interest debt is almost always more than what can be expected to be earned by investing in the market.

If your employer offers a match on 401K contributions, this makes the debt versus saving decision more complex.  If the company matches 50% of the first 6% of your salary, you are effectively earning 50% on that portion of your retirement contributions.  It would be difficult to earn this in the market with any degree of certainty, and the 401K contributions are also tax deferred, resulting in anywhere from 10% to 39% of deferred taxes on that income that is contributed to the 401K.  

Having retirement contributions automatically deducted from your pay eliminates the temptation to spend the money on things that could increase your consumer high interest debt.  Also, the contributions to the retirement plan can be used in an emergency, although they would be taxable and would also generate a 10% penalty upon withdrawal.  It is best to consult your financial advisor for strategies to reduce your debt and save for retirement.