If you’ve got debt, it can be tough to decide whether you should pay that off first or start saving for retirement. After all, both actions should be at the top of your financial priority list.
Everyone wants to save for retirement, but most people put this responsibility off until it’s too late to reach their retirement goals. If you’re interested in boosting your retirement savings, it’s important to take a more active approach. And we’re often told that the sooner we start, the better.
That said, if you’re carrying student loan or credit card debt, you might also be tempted to go beyond the minimum payment and make quicker progress to pay it down.
Different experts advocate different strategies for people struggling with debt while saving for retirement. This article will help you make a more informed decision and make the most of your money.
But before you start paying off your credit cards of contributing to a 401(k), there’s something you need to do first…
Do This First: Start with an Emergency Fund
Roughly four out of ten Americans can’t afford a $400 emergency, and it’s easy for unexpected situations to cost you much more. There’s no way to predict when an emergency will arise, and the last thing you want to do is go further into debt to cover unforeseen expenses.
With that in mind, it’s clear that a small emergency fund should come before anything else — even retirement and debt. An emergency fund gives you a cushion and allows you to start working toward other goals while knowing you’re covered for any situation.
This starter emergency fund should contain about $1,000, enough to pay for most unexpected circumstances. It won’t cover more major events like losing your job, but it will go a long way when something happens.
You should start contributing whatever you can toward an emergency account, even if it’s just $50 or $100 per month. Once you reach $1,000 (or your personal emergency fund goal), you can move on to the next step. If you don’t yet have an emergency fund, it should be your top priority.
Next, Take Advantage of Employer Matches
You might think that paying off debts should be the next step, but that often isn’t the case. Many people can use their money more effectively by contributing to an employer-sponsored retirement plan that includes matches on your contributions.
These programs give you the opportunity to effectively double your income up to the maximum match. As long as you have an emergency fund, contributing the highest possible match is the first thing you should do with any extra money.
If your employer matches contributions up to $3,000 per year, for example, you should contribute $250 each month to make sure you get the entire match. While you’ll pay a higher interest rate if you make only the minimum payment, you’ll more than make up the difference through your employer match.
Talk to someone in your accounting or HR department to learn more about your company’s policy.
Then Pay Off Debt
Once you’ve built up an emergency fund and started putting money toward an employer-sponsored plan (if you have one), you can begin to make more than the minimum payments on your debts. This will accelerate the payoff process and help you become debt-free more quickly.
Keep in mind that some loans charge penalties for paying off balances early. This is intended to prevent you from reducing your interest payments. In these cases, it’s usually best to continue making the minimum payment rather than paying the additional charge.
If you’re dealing with multiple debts, most experts recommend prioritizing those with the highest interest rates. This strategy helps you avoid as much interest as possible and spend less money to get out of debt. That said, any approach you can commit to is better than nothing.
You might also consider taking advantage of debt consolidation to simplify payments and reduce your bill. You can consolidate credit card debt with a balance transfer card that offers a low transfer fee and a long introductory period with no interest. These cards give you more time to pay off your debts without worrying about interest.
Make Additional Retirement Contributions
Further contributions won’t be matched by your employer, but you can still use tax-advantaged accounts to invest your money more effectively. In addition to your employer’s 401(k), you should consider opening either a traditional or a Roth IRA (Individual Retirement Account).
The key difference between traditional and Roth accounts for both IRAs and 401(k)s is the way your money is taxed. Your contributions are deductible in a traditional IRA or 401(k), reducing your taxable income as well as your tax bill (though some limitations apply — check with your tax advisor). Similarly, investments grow tax-deferred. On the other hand, that money will be taxed as regular income when you withdraw it in retirement.
Roth IRAs and Roth 401(k)s are essentially the opposite — you don’t get a deduction for the money you contribute, but your account grows tax-free and isn’t subject to taxation when withdrawn. In general, Roth accounts make more sense the lower your tax bracket is and the further you are from retirement.
Also keep in mind that tax-advantaged accounts have strict annual contribution limits.
Expand Your Emergency Fund
$1,000 may be enough for smaller emergencies, but major life events can cost much more than that. Once you’re debt-free, you should begin to grow your emergency fund to give yourself an even larger safety net in case something unexpected comes up.
Most experts recommend saving roughly three to six months’ worth of expenses, or more if you work in a field with high turnover. This will cover your living costs in case you lose your job, get sick, suffer an injury, or experience another circumstance that significantly changes your financial situation.
Navigating your finances can be incredibly confusing, especially when you’re worried about both debts and retirement savings. Working through these steps will help you make progress while covering the most important things first. You’ll have more financial freedom after paying off debts, building up your emergency fund, and adding to your retirement accounts.