Dave Ramsey recommends that you wait to invest until after all of your consumer debt is paid off except for your mortgage. I understand the logic, but I don’t think it is a one-size-fits-all solution.
Wait to Invest?
Dave Ramsey has a financial freedom program that includes baby steps. Investing 15% of your income for retirement is baby step number four, after a small emergency fund, paying off consumer debt, and, finally, a larger emergency fund. I agree with the steps but not necessarily the order.
Every dollar in debt repaid, is an investment in yourself and automatically increases your net worth. The thought behind the order of the baby steps is that you can’t afford to invest if you have obligations. The interest rate on your auto loans, credit card, and student loan balances will frequently substantially exceed your investment returns. Though I understand this is usually the case, I don’t think this should stop all investments.
Compound Interest
Investing for retirement requires compound interest and plenty of time. By stopping all investments until you pay off your debt means that you are losing months, if not years, of compound interest increases. Your deposits alone will not be enough to cover the amount of money required to sustain you through retirement. It is quite possible to outlive your funds, so you need to maximize the time of your investment period.
Retirement Accounts and Taxes
If you have an employer-sponsored retirement option that offers contribution matching, you should take advantage. At the very minimum, invest enough money to earn the match. The match is considered free money. In this scenario, your job is paying you to invest in your future. The employer match may not always be an option if your job decides to decrease its contribution or you change to a position that doesn’t offer it. For example, if you choose to be an entrepreneur, saving for retirement is a solo experience. Also, the annual contribution limit on employer-sponsored accounts is higher than other retirement accounts.
Additionally, contributing to a 401k or similar program reduces your taxable income. Paying off your debt may reduce your tax liability if you’re eligible for certain deductions such as student loan or mortgage interest paid. However, your tax rate may still be higher because your taxable income is higher. Reducing your tax liability is always a good idea.
Further, some investment vehicles phase out at certain income levels but have a lower annual contribution maximum, such as a Roth IRA. Maximizing your contribution each year of eligibility, ensures you have plenty of time for your money to grow. Also, a Roth IRA reduces your tax liability during retirement. If you spend your time paying off debt only, then you may miss your window for a Roth IRA as your income increases. At the age of 50, you can make catch-up contributions. However, you are still limited to how much you can deposit annually. You likely will not contribute enough to retire comfortably. You may also miss out on years of compound interest.
Use Dividends to Repay Debt
Finally, your investments can provide an additional stream of income if it pays dividends. You can choose to reinvest your dividends or have them paid to you in your brokerage account. You can apply this cash to additional debt payments during baby step number 2.
If you choose to stop all of your investments, make sure you determine the opportunity cost. A retirement calculator can estimate your balance for a certain period or how much to contribute every month to reach your goal. Keep in mind that there are annual contribution limits to retirement accounts.
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