How Much to Save for Retirement?
The general rule of thumb to successfully reach retirement is to save early and save often.
Those two simple steps allow compound interest to work its powers and easily set you up for retirement. Unfortunately, it’s a lot easier said than done. Especially for Millennials, who have more debt than any other generation, according to the New York Federal Reserve. Millennials — anyone born between 1981 and 1996 — are experiencing student loan debt, car loan debt and worst of all, credit card debt. Simple math suggests it’s probably better to pay off debt before saving for retirement, but one could argue that you should always save for retirement while paying off debt. One question you should ask yourself is, “how long will my retirement savings last”? Let’s first discuss the importance of savings for your future.
Best Way to Save for Retirement
As noted earlier, the power of compound interest makes starting your retirement savings as soon as you can a no-brainer. If your employer offers a low-cost 401(k) with a match, you should at a minimum be taking full advantage of that match. It’s common for an employer to match $1 for $1 up to 4% in a Safe Harbor 401(k) plan. By putting 4% of your paycheck into your 401(k), the company will then match your 4%. That’s a savings rate total of 8% of your income!
Albert Einstein once noted that the most powerful force in the universe is the principle of compounding. Compound interest, in layman’s terms, is earning interest on the interest you receive, which multiplies your money at an accelerated rate. For example, if you save $500 and earn 10% interest on that savings, you now have $550 in your account. If you earn 10% of interest on that, you end up with $605, and so on, until eventually your original $500 is completely eclipsed by the amount of interest you have gained.
Paying off Debt
Millennials have now collected over $1 trillion of debt. Whether it’s student loans, credit card bills or a car loan, it’s a troubling number that can hinder financial goals such as purchasing a house and building retirement savings. When paying off debt, one method is to make a list of all your money owed, while also listing the interest rate tied to that debt. If you have a mortgage, exclude this from your list. Credit card debt usually has the highest interest charge, so you will want to be more aggressive and it should be at the top of your list. You want to pay off the highest interest rate balances first, then make your way down your list.
Dave Ramsey said, “debt is not a tool; it is a method to make banks wealthy, not you. The borrower truly is slave to the lender.” Debt is a major obstacle when reaching one’s long term financial goals. Dave Ramsey’s “snowball” effect is also a common strategy to pay off debt. Pay off debt in order of smallest to largest, and you will gain momentum as you knock out each balance. When the smallest debt is paid in full, you roll the money you were paying on that debt into the next smallest balance. Becoming debt-free will provide you freedom to invest in other areas, such as your 401(k) plan.
Saving vs Paying off Debt
Most financial professionals estimate that over the long term, you earn an average of between 6% and 8% on retirement savings. The average credit card interest rate is 19.02%. Your money will work harder paying off the debt rather than invested for retirement. Student loan debt, on the other hand, has a low interest rate so you don’t have to be as aggressive in paying it off. For example, if you have a credit card interest rate of 15% and your average return in a 401(k) plan is 8%, you will want to pay credit card debt off before saving for retirement. If you have a student loan with a 4% interest rate, it would be better to save for retirement while paying the minimum payment for your student loan.
Anyone who is in the position to both pay off debt and save for their retirement should do so. Even if you have high-interest credit card debt, not taking advantage of your company’s 401(k) match is leaving money on the table. If your company does not offer a match, I would argue that paying off the credit card debt is more important.
Final Thoughts
There are a variety of strategies to consider when it comes to saving for retirement and paying down your debt, but it is important to play the numbers game when deciding what to do first. It often makes sense to save for retirement before getting aggressive about your debt. Credit card debt may be the only exception to that rule. Always take advantage of your employer’s 401(k) plan’s match, pay off high interest credit card debt fast and chip away at other debt while still saving for your retirement.
If your employer does not offer a retirement plan, please have them contact LT Trust as we offer great small business 401(k) plans.
