Every financial decision you make is a trade-off.
Would you rather have cable TV or an extra $80 per month towards your travel fund? Would you rather spend $40 on beers or a new pair of shoes? These are simple questions with easy answers, depending on your personal tastes.
Other times, it can be hard to tell which priorities to put first.
For instance, should you save for retirement or pay off debt from college first? The average graduate today emerges from college with $35,000 in student loan debt — how do you factor that into the mix?
While there’s no hard-and-fast formula that fits every person, you don’t have to choose between paying off debt or saving for retirement. Here’s how to balance both.
Start a Rainy Day Fund
Before we take a deep dive into the 401k vs. loans conversation, let’s highlight an important point: you need to have a “rainy day” fund, also known as an “emergency fund,” before you make any other financial moves.
This is the cash cushion that will save your butt when life takes an unexpected turn. If you lose your job in the same week that your car breaks down, you’ll be glad you have this fund.
Build a rainy-day fund that represents at least three to six months’ worth of your expenses.
Grab Your Employer Match
If your employer is generous enough to match any portion of your 401k contributions, start by contributing enough money to your 401k to at least collect your full employer match.
For example, let’s say your boss will match your contributions, dollar-for-dollar, up to 5 percent of your salary. Assuming you earn $40,000 annually, five percent would be $2,000. So if you manage to contribute this amount to your 401k, your employer will put in another $2,000 in free money.
Grabbing your full employer match is the only “guaranteed, risk-free” investment you’ll ever make. If you have the opportunity to capitalize on an employer match, make this your top priority.
Understand High-Interest vs. Low-Interest Debt
Next, let’s move on to talking about different types of debt.
“Debt” is a dirty word in most circles, and for good reason — being in debt ties up your money, both now and down the road. It forces you to pay several times over for the same purchase. It also prevents you from allocating your funds towards other financial goals.
But in reality, not all debt is created equal. Credit card debt often carries an extremely high interest rate — sometimes as much as 14 to 22 percent. Student loans, on the other hand, typically carry single-digit, fixed interest rates. This interest is also tax-deductible.
While all debt is a drain on your finances, student loans are the lesser of debt evils. Their interest rates are comparatively low, they offer a repayment period that varies from 10 to 25 years, and you may have the opportunity to further reduce your monthly payments by refinancing your loans.
While you don’t want to fall behind on your payments, you don’t have to be as aggressive about paying off your student loans as you should be with a high-interest loan such as a credit card. Prioritize paying off high-interest debt (anything with double-digit interest rates) before you start aggressively tackling your student loans.
Know Your Retirement Number (and What It Will Take to Get There)
With all this being said, how much money will you need for retirement?
Here’s a general rule of thumb to follow when determining your ideal retirement goal: aim to replace 70 to 85 percent of your pre-retirement expenses.
Let’s say that you and your spouse currently live a lifestyle in which you spend $80,000 a year. You’ll want to have 70 to 85 percent of that amount, or $56,000-$68,000, for each year in retirement.
Let’s grab the number in the middle: $62,000. Multiply this by 25, and you arrive at a value of $1,550,000. This is the amount you’ll need in your retirement portfolio (excluding any other sources of income) in order to achieve an income of $62,000 per year.
Multiplying by 25 allows you to withdraw four percent of your retirement income annually, a rate that financial experts generally consider to be the “safe withdrawal rate.”
Once you have your retirement number, consult one of the many free online retirement calculators to determine how much you’ll need to put aside each year in order to reach that goal by your planned retirement age.
Can you contribute this amount while still making the minimum payment on your student loans? If so, you’re in good shape. (If not, you may need to reduce your monthly expenses or take on a side hustle.)
At this point, we’ve established a few things about your financial situation:
- You’re collecting your full employer 401k match.
- You don’t have any credit card debt, or other high-interest (double-digit) debt.
- You have savings for a rainy day.
- You’ve calculated how much you need to save for retirement, and you’re meeting your retirement savings goals.
- You’re making your minimum student loan payments.
At this point, let’s assume that you still have money remaining. You’re trying to decide whether to use this money to make extra payments on your student loans, or make bigger strides towards your retirement savings. Where do you go from here?
Know Your Limits
Figuring out the answer starts with knowing your limits.
Take note of how far away you are from reaching the IRS maximum. There’s a cap on how much you’re allowed to contribute your 401k each year. In 2017, that limit is $18,000, or $24,000 if you’re over the age of 50.
Also, take note of how close you are to obliterating your entire student loan balance. How soon would you be able to erase all of your debts?
If you’re close to maxing out your retirement account, you might decide to reach that maximum threshold. Cross it off your list; be done with it. At that point, you can turn your full energy towards aggressively repaying your student loans.
On the other hand, if you’re close to repaying all of your student loans in full, you might choose to wipe out the remainder of your debt balance. At that point, you can devote all of your energy towards building your 401k.
If you’re not close to either goal, then you’ll need to make a judgment call. Do you want to split your extra money 50/50 between saving more aggressively in your 401k and repaying your student loans? Or do you want to emphasize one goal over the other?
At this point, your decision becomes personal. Which of these two issues keeps you awake at night? Which result would give you more satisfaction?
Finally, you’ll also want to check the terms of your student loans to make sure they don’t have any prepayment limits. The vast majority of student loans don’t charge a fee for prepayment, but there are some that do, and if yours is one of them, that will have a definite effect on whether you choose to divert any extra funds towards your retirement or your student loans.
In the End
How you handle your money is based on a number of personal factors, from your current debt load to how much you’ve already put aside for retirement.
The best strategy is to balance both short- and long-term goals. Chose a goal that gets you excited, and you’ll set yourself up for a happy and secure future.
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