The key to successful retirement planning is the proper allocation of assets, not just according to age and risk tolerance, but across asset classes as well. One of the most common mistakes in retirement planning is to allocate the bulk of retirement savings to a retirement account while making minimum payments on outstanding credit card debt. The better strategy is to minimize contributions to retirement savings and maximize the payments to credit cards to retire the credit card debt.
Significance
The importance of retirement savings cannot be overstated. If your employer offers a sponsored retirement saving plan, taking advantage of it not only saves money for retirement but also lowers your current tax burden. However, if you carry a large revolving balance on credit cards, you are negating some or all of the potential growth of the retirement account. Contribute the minimum required to take part in the retirement account, and the maximum allowed to equal any employer matching, but use the rest of your retirement savings allocation to pay off credit card debt.
Time Frame
Over time, the power of compound interest can work for or against an investor. Good investments benefit from growth over a long time, but the losses from bad inv5estments are exacerbated in the same way. It does an investor little good to earn five percent per year on his retirement account if he is being charged 15 percent or more on his revolving credit card debt.
For example, the average credit card APR in June 2010 was 14.31 percent. If an investor has $8,000 in credit card debt and only makes the minimum payments in order to maximize contributions to his retirement account, the credit card debt will take more than 30 years to pay off and the investor will pay a total of $31,300.
Considerations
When deciding between funding a retirement account or paying off credit card debt, ask yourself which has the better guaranteed return. Chances are, the retirement account won't guarantee a return at all and if it does, the return will be less than five percent per year. Now look at your credit card statement. Your interest rate could be 15 percent per year or higher. By paying the credit card off, you are no longer going backward by 15 percent per year.
Benefits
A benefit of many employer-sponsored 401k plans is the ability to take a loan from the account and then repay yourself with interest. This benefit can be used to retire the credit card debt causing negative annual returns. For this strategy to be most effective, however, the credit card accounts must be closed after being paid off to avoid the temptation of running up credit card balances again. Handled properly, the credit card debt is paid off, the credit cards are closed and you make a fixed monthly payment with interest to your own retirement account.
Warning
No retirement savings plan will be successful unless the investor learns to live within his means before retirement. Retirement almost always entails a significant decline in annual income, and those investors who haven't learned to control spending run the risk of outliving their retirement savings. Developing the habit of paying cash for everything early in life will pay big dividends in retirement.
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