Pay off Debt or Maximize Retirement Savings?


NEW YORK (MainStreet) — The message has been hammered home time and time again: save for retirement -- you – must -- save – for – retirement. Americans are saying, "Message received." And since the financial collapse, there has been a major shift in priorities among the so-called "mass affluent." Retirement saving is now the top priority of 39% of Americans, followed by paying down debt (26%), according to a Bank of America Merrill Edge report. This is a complete reversal since the 2008 money meltdown.

Somehow, we're placing a priority on saving for retirement over paying off debt. But won't the financial experts say we've got it all wrong? Aren't we supposed to pay off the debt -- and then start setting aside retirement savings?

You come in here with a skull full of mush

"Depends on the debt," says Shane Fischer, an attorney in Winter Park, Fla. "If it's a low interest rate debt that is tax deductible, why not save for retirement first? You get the tax benefits of retirement contributions with the tax write-off of the low interest on the debt. And since you are limited to the amount of 401(k) or IRA contributions you can make every year, why not maximize those contributions first? Additionally, if your debt burden forces you into bankruptcy, your 401(k) contributions are protected from creditors. So if you're going to declare bankruptcy, wouldn't you want to keep as much money as you can?"

Fischer is "thinking like a lawyer," as John Houseman portraying crotchety Professor Kingsfield so famously spewed in "The Paper Chase." But what do the financial advisors say?

James D. Osborne, president of Bason Asset Management in Loveland, Colo. says the debt comes first.

"High-interest consumer debt -- anything carrying a higher rate than your mortgage payment -- should be treated as an emergency," says Osborne. "This means credit cards, auto loans, personal loans - like the one you borrowed for that European vacation - private student loans and home equity loans. Once these loans are eliminated, it's appropriate to first build an emergency fund of three to six months of living expenses and only then start saving for retirement. The only exception to this rule is that investors should always contribute enough to earn their company match in a workplace 401(k)."

In other words, pay the debt first -- unless you get a 401(k) company match.

Put your investments in prison

But, not so fast, says Nancy D. Butler, an advisor in Waterford, Conn.

"The fact that you have built up this debt says that you have had difficulty managing your finances," Butler says. "If you apply the funds you have available to reduce the debt, what is to keep you from building the debt back up again? And, you will still have no retirement savings."

So save for retirement first?

"Although the debt typically has a cost associated with it, sometimes you can come out ahead financially by applying any money available above the required minimum debt payment, to save for retirement," says Butler.

She goes one step further. And I have to admit, I haven't heard this as being a positive investment strategy before: tie the retirement savings up with big withdrawal penalties.

"I often suggest applying the retirement savings to an account that has a high surrender charge if you withdraw it too soon," Butler says. "Between the surrender charge, 10% penalty for withdrawing before age 59.5, and federal and state income taxes, a withdrawal could cost you 50% or more of every dollar you withdraw. This cost can be a deterrent and therefore help to save the money [rather than] spending it and not having a reasonable retirement."

And so we all agree: save for retirement first.

Paying your future self

Rachel McDonough, a financial planner in Bloomington, Minn. slices the issue with more subtlety.

"I believe that debt is only truly safe for those who don't need it; those who could simply write a check and pay it off anyways," says McDonough. "If that's not you, then your debt load puts pressure on your future earnings and reduces your financial freedom. Plus, stock, bond or mutual fund retirement investments have no guaranteed rate of return. Sometimes they lose money. But paying off expensive debt guarantees you a savings in the total amount of interest you'll pay."

Ell Kaplan, a "female finance CEO," agrees with paying off high-interest debt, but low-interest bills like student loans can be slowly satisfied with minimum payments.

"In investing, the most precious resource is time," Kaplan says. "By waiting until all of your loans are paid off, you will have detracted extremely valuable time during which you could be contributing to your retirement resources. Think of it as paying your future self, and make it as non-negotiable as any other bill."

The definitive answer

One advisor has considered both sides of the issue, created a definitive strategy – and then changed his mind.

"I too have read the 'book' advice about paying off debt before saving for retirement," says Thom W. Newcomb, a financial advisor in Pensacola, Fla. "However, about five years ago I abandoned this philosophy and made a 180 degree turn and began advising clients to focus on savings and less on paying off debt."

Newcomb cites the following reasons:

  • 1. In reality, there is a psychology to debt. Everyone has an "acceptable debt threshold," so paying off debt is a never-ending battle. The moment it's paid off, most consumers with no debt will soon take on new debt within their threshold. So focus on savings and simply keep debt under control.
  • 2. Newcomb began asking clients a simple question, "Would you be comfortable if we didn't pay off the debt but you had the money where you could pay off the debt at any point, if you wanted to do so?" Clients would almost always answer "yes."
  • 3. And generally, he says a client can make more than he or she pays with compound versus simple interest. Cash is King. Plus he takes into consideration the tax advantages of investments and interest payments, such as mortgage interest.

And Newcomb is dead set on his debt-last strategy.

Oh, wait. With two exceptions: clients with high interest rate credit cards or loans, and people who are above their "acceptable debt threshold."

--Written by Hal M. Bundrick for MainStreet

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