A different path: saving for retirement before tackling debt

Every day we hear from people who are diligently paying down their student loans — and ignoring their retirement funds. This has got to stop.

Yes, debt can be costly, but failing to save for retirement ultimately will cost far more.  Here’s why:

1. Matches: When there’s a company match for your 401(k) contribution, that’s typically an instant return of 25% to 100% on your money. Although there are “catch up” provisions that allow people 50 and older to contribute more to their accounts, you never get back the matching money you missed.
2. Tax breaks: Retirement contributions reduce your taxes, typically by 15% to 50%. (There’s a Saver’s Credit for lower-income taxpayers, who may not get much if any deduction). Paying off debt instead of saving for retirement doesn’t help your tax burden and can even increase it, because interest on student loans and mortgages is typically deductible.
3. Compounding: There’s no better time to start saving hard for your retirement than in your 20s. That’s because the earlier you put money into a retirement fund, the longer it has to grow. Money contributed in your 30s can grow 10 times by retirement age, assuming typical stock market returns. In other words, $1,000 can turn into $10,000. The same $1,000 contributed in your 20s can grow 20 times, or to $20,000. (See compound interest in action for yourself.)
4. It gets harder and harder to catch up: The longer you delay retirement savings, the more you have to save to get to the same place. People in their 40s would have to save about 30% of their incomes to match what they would have if they had started saving 10% in their 20s. By their 50s, they would have to save more than 40% of their incomes. Roger Ibbotson did the math in his National Savings Guidelines for Individuals and found that getting started after about age 35 meant having to save so much that most people will find it impractical, if not impossible, to save enough for retirement.
5. By the way, returns don’t matter (much): Too many conversations about paying off debt focus on the “guaranteed” returns of doing so versus the “speculative” returns of investing. But the returns we get actually matter a lot less to our ultimate wealth than how much we chose to save. Households that choose to save more wind up with more wealth across the income spectrum.
6. Life happens: When you delay retirement savings, you’re making a bet that things won’t go seriously wrong in the future. Your later earning years may be interrupted by layoffs, illness, accidents or the need to care for family members. Just when you need to put the pedal to the metal on retirement savings, someone takes away the car.
7. Financial flexibility: Money used to pay down student loans and many other types of debt is gone for good. You can’t get that cash back if you need it for an emergency — and you need a way to handle emergencies.

Got toxic debt?

It can make sense to prioritize high-rate “toxic debt” over retirement savings when the debt can be paid off fairly rapidly. Toxic debt includes all payday loans and most credit card balances. You would still want to contribute enough to a retirement plan first to get any company match (because it’s free money), but the rest of your retirement contributions can wait until the toxic debt dragon is slayed.

That assumes the dragon is slayable, of course.

If it would take you five years or longer to pay this and other consumer debt, such as medical bills and personal loans, then you should consider debt relief. Why five years? Because that’s how long you would be required to make payments on such debt in a Chapter 13 bankruptcy repayment plan before your remaining balances are erased.

And five years is about the maximum I’d want anyone to put retirement savings on hold, given what we know about the growing retirement crisis in America. The reality, reflected in every survey of American finances, is that most people have manageable debt loads but many have far too little saved for retirement.

Here are a few telling statistics:

• In the latest Employee Benefit Research Institute’s Retirement Confidence Survey, 42% of workers — and 27% of those 55 and older — said they had less than $10,000 saved.  EBRI has predicted that more than 40% of baby boomers and Gen Xers will run short of money in retirement and be unable to meet basic expenses plus health care costs.

• By contrast, one-quarter of U.S. households had no debt in 2013, according to the Federal Reserve report. Just 8.2% of debtors had debt payments that totaled more than 40% of their incomes, a payment-to-income level that indicates financial distress.

• Most American households have no credit card debt. About one-quarter of households don’t have credit cards, while another 35% to 40% pay their balances in full each month. The median family with a credit card balance carried $2,300 in 2013, the latest year for which Fed statistics are available.
• Even student loan debt, the supposed bane of millennials’ existence, is manageable in most households. The average share of income devoted to student loan payments in households headed by people under 35 with college degrees is 3.8%, the Fed says.

Clearly, people are still overdosing on debt. About 1 million Americans file personal bankruptcies every year, and nearly 7 million have defaulted on their student loans. Foreclosures are down from their peak, but more than half a million homes were in some stage of foreclosure at the beginning of 2016, according to real estate research firm CoreLogic.

For tens of millions of households, though, skimpy retirement savings pose a bigger danger to long-term wealth than their debt. Paying off low-rate, potentially tax-deductible debt such as student loans and mortgages should not take priority over building their defenses against an impoverished old age.

Liz Weston is a columnist at NerdWallet, a personal finance website, and author of “Your Credit Score.” Email: lweston@nerdwallet.com. Twitter: @lizweston. This article first appeared in NerdWallet.