How to Save for Retirement While Getting Out of Debt

We all want to reach a point where we don’t have to work for a living. We’d like to relax and enjoy life without any financial stress. Of course, that won’t happen if you don’t save for retirement. But how can you save if you’re in debt? There are a few things to consider when you’re trying to balance saving for retirement with paying off debt.

We’ve asked how you juggle saving and paying off debt before. It’s a complicated question that depends on a variety of factors. Here’s what you should consider.

Before Anything: Build an Emergency Fund

Before you think about investing your money vs. paying off debt, make sure you have an emergency fund in place.

It seems counterintuitive to build up a savings cushion while you’re in debt, but it’s a crucial step to avoid getting stuck in a debt trap. So build up a small amount of savings while making your minimum debt payments. Most experts recommend saving at least three months’ worth of living expenses, but even a few hundred bucks is better than nothing.

When I was getting out of debt, it would’ve taken me forever to save three months’ worth of expenses, and I wanted to get out of debt fast. At first, I tried going without an emergency fund altogether. That didn’t go over so well. When the inevitable emergency popped up, I’d put it on a card and my debt progress was immediately undone. So I compromised and saved $1,000 for an emergency. It wasn’t as much as experts recommend, but it was enough to pay for small setbacks without undoing my debt progress. But I also had an emergency plan, in case of a bigger emergency: move back in with my family (who preferred me to stay at home, anyway). So I had options for every scenario.

Over at Bankrate, personal finance author Paula Langguth suggests systematically saving and paying off debt by creating milestones. For example, once you reach $500 in your emergency fund, increase your minimum debt payment by a certain amount, then reduce your emergency fund savings. At $2,000, increase your payments more, reduce your savings amount even more, and so on.

Take Advantage of a 401(k) Match

So you’ve saved for an emergency, and you’re making the minimum payments on your debt. If you’re lucky enough to work for a company that matches your 401(k) contributions, it’s time to take advantage of it.

After all, this is free money. Say your company matches half of what you contribute to your 401(k), up to 6% (a pretty common scenario). That’s a guaranteed 50% return. You don’t get this anywhere else, so don’t pass it up. This rule is pretty much universally true for anyone that has a 401(k) match, regardless of your age or debt.

Of course, since it is free money, some people might be torn between taking advantage of the match and saving for an emergency. Just remember: an emergency fund is meant to protect you. If you find yourself in financial trouble, and you don’t have anything saved, you might be forced to go further into debt. You could take the money out of your 401(k), but then you’ll pay a penalty. It’s best to have a small money cushion in place.

But what if you can’t afford to make the match? Here’s what Money Under 30 suggests:

But even if this type of contribution is putting the squeeze on your budget, you can always opt to contribute 4 percent of your pay, to get a 2 percent employer match, or even contribute 2 percent of your pay to get a 1 percent employer match. Sometimes you don’t have to turn the faucet off – you just have to lower it to a trickle. If you can do this while prioritizing paying off debt, you’ll come out ahead in the end.

In short, take advantage of it as much as you can. That’s another mistake I made when paying off debt. I prioritized my debt goal, which was awesome, but I also skipped my 401(k) match at first. I figured I couldn’t “afford” to save for retirement since I was in debt, so I essentially passed up free money from my employer.

Figure Out Which Goal Is More Important

After building an emergency fund and saying yes to free money, the balance of paying off debt and saving isn’t so black and white. Debt is almost always the biggest priority. But ask yourself the following questions to figure out how to prioritize it along with your retirement.

How Close Are You to Retirement?

If you’re getting close to retirement age, saving is going to be more of a priority. How much to save will also depend on your income, your debt payments, and how close you are to retirement.

Personal finance writer Ramit Sethi says there are three ways to think about how to prioritize:

• The mathematical answer is to put your money where it will have the biggest impact. If your debt interest rate is lower than what interest rate you can expect from investing, pay the minimum on the debt each month and invest the rate.
  
• The emotional answer is that for many people, they hate having debt of any kind, so even if they’re paying off low-interest debt, it still makes sense for them.
  
• The hybrid approach is to split the difference: Pay off some of the debt and invest some. A nice compromise.
  

Most people automatically lean toward the mathematical answer, which makes the most sense on paper. But personal finance has a lot to do with mindset, so Sethi suggests the hybrid approach. It might especially be the best compromise if you’re nearing retirement age.

As a rule of thumb, you’re supposed to save 10% of your income for retirement, but that’s not always possible. If you’re playing catch-up, you might need to contribute as much as you can. Use a retirement calculator to help figure out where you should be, and how much you need to save to get there.

You still want to head into retirement as debt-free as possible, though. So whichever approach you choose, getting rid of your high-interest debt should still be a priority.

What Kind of Debt Do You Have?

Add up all of your debt and take a look at your interest rates. Forbes contributor Laura Shin suggests:

Write these down in a spreadsheet from highest interest rate to lowest interest rate. Include everything from credit cards to car loans to your mortgage to student loans. This list will be helpful when trying to prioritize your debt payments against the potential growth of your retirement contributions.

If your interest rates are incredibly low (for example, let’s say you have a 0% car loan), it’s probably okay to postpone it while you save. Make your scheduled monthly debt payments, but then use your extra income for savings.

And then there’s your mortgage. It’s tempting to pay off your mortgage early, but most experts recommend focusing on saving for retirement first. As nice as it is to pay off your home, you want to take advantage of time when it comes to investing—you’ll come out ahead in the long run. Financial guru Dave Ramsey suggests investing 15% of your income for retirement before you work toward boosting your mortgage payments.

But if you’ve got high-interest, revolving debt, like a credit card, it should be your first priority.

As a general rule of thumb, Financial planner Sophia Bera recommends tackling any debt with an interest rate of 6% or higher. This advice is probably based on the general assumption of a 7% average market return—if you have debt under 6%, you’d likely come out ahead by prioritizing investing. So, if you’re dealing with a debt below that, you might consider focusing on retirement. Of course, if you’re dealing with multiple debts, you want to add up all of the interest you’re paying on your total debt each year and compare it against how much you could earn saving for retirement.

Do the math, and make sure you’re not paying more in interest than you could earning a return.

What Does Your Credit Look Like?

You might also want to focus on debt if you’re trying to boost your credit score.

Credit utilization makes up 30% of your FICO score. It’s basically the amount of credit you’re using compared to the amount you have available to use. The lower your debt-to-credit ratio, the better your score.

If you’re trying to get a mortgage or buy a car, you might need to prioritize debt so you can improve your credit.

Overall, it comes down to the numbers. You can contribute to both goals at the same time, but you should at least know which one takes priority. Once you do, come up with a plan.

Budget for Both Goals

We’ll assume you have a basic budget in place to account for your living expenses and discretionary spending. After that, you’ll want to decide how much of your income to throw at debt, then how much you can afford to throw at retirement. Shin offers a guideline:

1. Calculate how much money you have to throw at your financial goals, after drafting your basic budget
2. Add up the minimum payments on all of your debts.
3. Subtract #2 from #1.
4. Decide how much to allocate to each goal. If you have high-interest debt, you’ll probably want to allocate 100% for now. For all other debt, adjust your percentage based on the above factors.

Again, you might consider setting a milestone for saving, then increasing your debt payment as you reach that savings goal. Or, vise versa: after paying off a certain amount of debt, you may decide to increase your retirement contribution.

Both getting out of debt and saving for retirement are important financial milestones. Tackling them both simultaneously can be a difficult balancing act. Taking stock of your situation and drafting a plan will help you come to a compromise and ensure you make the smartest financial decision for both goals.

Photo by Christian Schnettelker.

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