Don't Let Debt Paralyze Your Retirement Planning
If you are like many of the dental students I speak to, you may have $300,000, $400,000 or even $500,000 in student loan debt upon graduation. You may have also added more debt in the form of a house payment, in addition to the cost to buy into an existing dental practice. You may easily be walking around with $1,000,000 or more in debt.
It is at this point in your life that a well-meaning relative, parent, mentor, or friend will say to you, “Whatever you do, pay off all of your debt before you do anything else.” Though this may seem like sound advice, there is more than one way to handle student debt.
Despite common misconceptions, paying off all debt as soon as possible is not necessarily the smartest option. Once you start earning a paycheck, you have the chance to leverage what is considered the eighth wonder of the world — the power of compounding interest (the power of time and money). If you delay contributing to your retirement plan because you are making extra payments on your debt load, you’ll never get the time back that your investments could have been growing and compounding.
Let’s walk through a few examples.
Invest 10 percent of income starting at age 22
Let’s say the starting salary for your first job is $30,000 per year, and you decide to put 10 percent of your salary into your 401(k) retirement plan. You then decide to put your 401(k) contributions into a low fee stock index fund, thereby minimizing your expenses. Assuming your income remains the same and without considering a company match, your $3,000 annual contribution, starting at the age of 22, will grow to about $850,000 at age 65. For those scoring at home, that’s using a seven percent rate of return, which is the ballpark historic return of the S&P 500, after accounting for inflation and dividends.
Remember, this example is conservative, as it assumes you never get a raise and doesn’t include a company match.
Invest 10 percent of income starting at age 30
Say you have graduated from dental school, are working in a practice, and are 30 years old. Even though you have significant student loan debts to pay off, you have decided to put 10percent of your $200,000 annual income into a 401(k) plan. You invest that $20,000 per year into the same stock fund that generates a seven percent return. Since you start contributing at age 30, you now have 35 years for the amounts to grow. Because of this head start, that ten percent contribution will grow to about $3,100,000 by the age of 65.
Again, this example is conservative, as it assumes you never get a raise and doesn’t include a company match.
Invest 20 percent of income starting at age 45
Now let’s say you have graduated from dental school, are working in a practice, and have been busy paying off all of your debt. You have focused exclusively on paying off student loans, practice loans and home mortgage debt. At the age of 45, you finally become debt free and are ready to focus on retirement. You decide you have to play catch up and contribute 20 percent of your $200,000 salary into a 401(k) profit sharing plan.
However, since you are now 45, your money will only have 20 years to compound. How much will that $40,000 per year grow by the age of 65? Only about $1,900,000! Even though you had the self-discipline to make some difficult lifestyle changes and you saved 20 percent of your annual income (doubling the savings percentage in the first two examples), you lost out on 15 years of the power of compound returns. Due to a lack of planning ahead, you ended up with over $1,000,000 less in retirement savings.
The Power of Time
Why is there such an incredible difference between starting your retirement savings at age 45 versus age 30? Even though you doubled your annual savings, you lost the power of time, which is something you can never get back. Money saved today for retirement is more valuable than money saved tomorrow—literally, thanks to the compound interest earned by your accounts. Think of it as a reasonably paced jog toward retirement, if you start now, versus a mad dash to the finish line, if you wait until years later.
How can you start jogging towards retirement?
So – do you have enough for retirement? Are you on track? A financial planning tool called a “Monte Carlo analysis” can discern your optimal retirement distribution amounts based on your assets, spending patterns, life expectancy, earnings and tax rates. You should have an analysis prepared by your financial advisor several times prior to retirement as well as after the sale of your practice. It sets guideposts on current spending so you’ll have adequate savings as you age.
Key points to remember about debt and retirement
Good debt is using long-term, low-interest rate financing in order to free up current cash flow, which allows you the flexibility to deploy cash into retirement investment opportunities with greater return potential. Paying the minimum amount on low-interest loans allows you to free up cash for your retirement plan.
A 401(k) offers immediate tax benefits
Your 401(k) contributions are made with pre-tax dollars, and you don’t pay taxes until you withdraw money. Any investment earnings are compounding tax-free until a withdrawal is made. Since your money is contributed before taxes, you receive an immediate tax deduction because you are reporting a lower income. In the future, when you withdraw your money from your account, you have to pay income taxes on the amount you withdraw.
Pay down high-interest debt first
It can be easy to run up a large credit card balance as you are getting up and running. Once you do, it’s not easy to pay off. The minimum payments are typically low, which means you are paying mostly interest, so it will take much longer to pay off the balance, costing you even more. If you can, consider making it a priority to pay off high-interest credit card debt before you tackle other debt.
The choice is yours, and it will determine your future.
The best day to start saving for retirement is the day you get your first paycheck. The next best day is today. You can’t change the past, but what you do today will impact your future and how you live in retirement.