What do you do if you are loaded down with credit card debt but you know you should be saving for retirement? Do you concentrate on getting rid of the debt, and put off saving in the 401(k) or IRA for later? Or do you save now, pay off later?
The first answer may make you feel better and perhaps move you further in the long run. The other is actually the best answer but will only work if you are disciplined about getting rid of credit card debt.
Feel-good approach: I suggest young people combine getting rid of credit cards with some retirement saving at the same time.
That way you move yourself along on your debts and on your saving. Best of all, you start seeing your savings build up and begin to imagine spending retirement comfortably instead of sitting in your La-Z-Boy without cable TV.
This route deals with the psychological boost many people need.
Consider the difference between a 20-year-old who saves a little each week, and a 45-year-old with nothing saved.
If the 20-year-old invests just $20 a week in a stock market mutual fund in a 401(k) or an individual retirement account, she can end up with $1 million at retirement if the stock market performs the way it has historically.
At 45, a person who has saved nothing will need to save about $245 a week to end up in the same place.
I assumed both average 10 percent annually on investments. That’s the average in the past 86 years, although too high for the past decade.
Numbers approach: David Blanchett, head of retirement research for Morningstar, did an analysis purely based on the numbers.
He found that if you wipe out the credit card debt, you can then save for retirement with better results.
His calculations show that you can potentially increase your 401(k) balance by 14.1 percent over the person who just made minimum payments on credit cards while also saving for retirement.
Blanchett assumed that the person had $400 a month to be used either for credit card payments, the 401(k) or both.
A 30-year-old with $15,000 in credit card debt, he said, who simply paid the minimum on the cards wouldn’t get rid of the debt for 36.6 years, ending up debt-free five months before retiring at age 67.
But if the person devotes the full $400 a month to paying off the credit cards, the debts would be gone in 6.6 years.
At that point, the person would start routing the entire $400 a month into a 401(k).
By retirement, Blanchett said, the person would have $380,516.
Blanchett assumed for his example that the person’s employer was not providing any matching money on the 401(k) plan.
If a match had been provided, Blanchett said he would advise putting enough money into the 401(k) each month to get the full match.
Then, he said, anything left from the $400 a month would go toward paying off more than the minimum on credit cards.
The reason minimum payments continually hurt is because interest keeps building.