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Retirement vs. Paying Off Debt: How to Decide

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A couple weeks ago, a friend came to me with a dilemma.

Actually, not a dilemma, really, but a first-world problem that I bet we’d all like to have.

Her income increased, and now she needed a plan. What should she do, she asked?

I was happy she asked me because I’ve made myself (through my many mistakes) a bit of a personal finance dork, at least about paying off debt. I love numbers, and I love helping people figure out the best course for them financially. I don’t have any experience in “how to deal with all this extra income,” but she knew I could offer unbiased help.

The fact of the matter is, most people have a very hard time adjusting to a sudden windfall. The way raises usually happen is a step-by-step approach. Five percent here, 10 percent there, just enough to let lifestyle inflation creep up a fair amount. Although my friend’s new job isn’t a windfall per se, she knew she’d have a lot (though not twice as much, funny how that works) more money in each of her paychecks. She’d been living on the frugal line for so long that she wondered what she should do with the surplus. Should she contribute to retirement or pay off debt?

So, here’s the story: my friend (let’s call her Sheila because she’d like to remain anonymous) was on the market for a new job. She earned her MBA three years ago, and she found it difficult to find a job that challenged her upon graduation. Instead, she took a different job — one that paid a lot less than she expected, and one that didn’t challenge her at all. But she kept doing a good job, and was looking for a new job the entire time she was there. It looked like nobody was hiring or at least, nobody better than where she was already. She wasn’t just looking for something different. She wanted something better.

She’d nearly given up searching for jobs, and she had decided to stop looking at Craigslist because it felt inefficient. “What the heck?” she thought. “One last look.” And she found something great. A consulting firm was looking for people like Sheila, and the pay was way better! In fact, within 24 hours of her interview, she was looking at a job offer that paid double what she was making before.

Sheila’s first thought was to upgrade her lifestyle. Gosh, she could use a new car. And what about this studio apartment she was living in? Surely she could upgrade that. But then she reconsidered. She didn’t need a new car, and she definitely didn’t need a new apartment. Nothing had changed, really, except that roughly twice as much income would be coming through her accounts. If she upgraded her stuff (which is such a common mindset), she wouldn’t feel any better off financially.

So she took a look at her options …

Option 1: Max Out 401(k)

Sheila’s company offers a 401(k) without a match. She hasn’t put much toward retirement, and she’s already 35. She can put $17,500 toward her 401(k) (and so can you, if you have one!), and because she has so much more money to work with, this seems like a viable option.

Option 2: Max Out an IRA

Sheila could instead open an IRA (either traditional or Roth) and contribute $5,500 toward that. She’s still saving for retirement, but she’s putting less money in there.

Option 3: The $70,000 Elephant in the room

Sheila’s MBA didn’t come for free. In fact, she has over $70,000 in student loans! Her loans are all at different interest rates, but the lowest is 6.5%. Seriously. That’s a staggering sum, and student loans stay with you forever, even if you declare bankruptcy.

We’ve mentioned this before, but it bears repeating: the only time you’re ever “earning” a guaranteed interest rate is when you’re paying interest on something.

My Advice:

I told her to live exactly as she’s been living for the past three years, and put every extra dollar toward that mountain of student debt that’s weighing her down. She could be free of them in under three years if she really prioritizes. After that, she can start aggressively saving for retirement.

If she prioritizes retirement savings, the student loan debt doesn’t go away. In fact, it stays there until she can pay it off. Could she earn 6.5% investing in an index fund? Maybe, maybe not. But there’s no guarantee. Once she finishes paying the loans, then she’ll have more money at her disposal to do what she wants.

What would you tell her? Do you agree that paying off debt is a high priority?

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