Should I be investing while paying off debt?
This question has been heavily debated over time. But it should be evaluated on an individual basis. Personal finance is just that: personal. You are the one in control and the one who has the final decision in the financial path you choose.
There are two general opinions here. The first: don’t invest any money while you have debt. Dave Ramsey, a well-known financial advisor and author, preaches that you shouldn’t invest until all consumer debt is paid off, such as student loans, car loans, credit cards, etc.
The second opinion: you can invest while you are paying off debt. With this option, the question then becomes what type of account(s) to use and how much to invest. It all goes back to what is comfortable for you. Because this is personal and shaped to your goals and what you want to achieve, regardless of the approach you take, the end goal is roughly the same- to eliminate debt and build wealth.
The only way to build your net worth is to pay off debt.
Where to invest?
People tend to think that the 401k is the first opportunity to invest. Unfortunately, many tend to overlook the Roth IRA (Individual Retirement Account), Traditional IRA, and 457 options.
401k / 403b
401k and 403b are tax-advantaged retirement accounts that most employers offer to their employees. Additionally, employers typically offer an employer match where they match some or all of the funds contributed by employees. For example, if you are contributing 5% of your salary to a 401k, then your company will also contribute 5% to match that amount. This is essentially free money that should be utilized whenever possible. Funds are deducted pre-tax from each paycheck and taxes are deferred until the funds are withdrawn. As of 2021, the maximum contribution to a 401k or 403b is $19,500 per year if you’re under the age of 50 and $26,000 per year if you are over the age of 50. Because these accounts are designed for retirement, funds cannot be withdrawn until age 59 ½ or it will incur penalties.
Roth IRA / Traditional IRA
The Roth IRA and Traditional IRA are two additional types of tax-advantaged investment vehicles that you can utilize if you have earned income. The main difference between these two is how they are taxed. The Traditional IRA is money you are investing before you pay taxes on it. You’ll owe taxes when the funds are withdrawn. The Roth IRA is money that has already been taxed, such as take home pay. Since the money has been taxed, the Roth IRA grows tax free and you won’t owe taxes when you access the funds. The maximum contribution for a Roth IRA is $6,000 per year while you’re under age 50. Over age 50? The max is $7,000 per year. Both types of IRA funds can be accessed without penalty after you reach age 59 ½.
Because Roth IRA contributions are money that has already been taxed, all contributions made by you (not including any capital gains) can be withdrawn early without penalty.
Investing $500 every month into a Roth IRA in your early 20s over a period of forty years, accounting for the average annual return of the stock market (8%), will grow to approximately $1,700,000. But what if you can’t afford that $500 per month? No worries. Just start with something. Even if you invest $250 every month over the same timeframe you would still end up with approximately $840,000.
A Roth IRA is an investment vehicle, not the investment itself. If you put $100 into your Roth, you need to direct where you want that $100 to go, such as an index fund or individual stocks.
Consistency is key. Start with any amount.
457
Some state employees are offered a 457, a governmental retirement account also known as Deferred Compensation. It’s a tax-deferred account where employees can take their money out as soon as they leave their employer (known as separation of service) and do not pay early withdrawal penalties if they are under age 59 ½. If you are offered this type and don’t think you’ll be working when you reach age 59, consider taking advantage of this option due to penalty-free withdrawal.
What to invest in?
Make it simple. Start with a low cost index fund that tracks the S&P 500 or the total U.S. Stock Market.
When picking investments in a 401k or other account, pay attention to the expense ratio. Higher expense ratios may look harmless at the start, but over time when the account balance grows to a substantial amount, you could be paying thousands per month in fees associated with the fund. The key here is to find investments (if possible) that have a very low expense ratio that track major indexes.
Understand if the fund is passively or actively managed.
Index funds that track the S&P 500 and other large markets are passively managed. Actively managed funds are run by professional financial advisors who manage your money for you, which is why most actively managed funds charge much higher expense ratios than a passive index. Shoot for an expense ratio lower than 1.00%. If all the options are higher than 1.00%, you may want to consider other options.
Consistency is key. Start with any amount.
Real Estate
Another way to build your wealth is through tangible assets. Real estate can be a great alternative if you’re not interested in stocks. There are numerous ways to become involved in this sector, such as house flipping, owning rental properties, lending money to other investors where you earn appreciation, being an agent, etc. It can also be a great additional asset for those who want to further diversify their portfolios. At the end of the day, it all comes back to you and the strategy you feel comfortable with. Again, this is personal.
Conclusion
Realize that financial independence will not happen overnight. Don’t be intimidated by other peoples’ success. Everyone starts with a $0 balance. Have a long-term mentality for your investments. Make use of the tax-advantaged accounts and understand the benefits and parameters of each one available to you. If possible, pay off your debts to the best of your ability as soon as possible. If you have an employer match, try to take advantage of that while paying off debt. No employer match? Don’t sweat it. Simply focus on paying off that debt so you can start investing with freedom, or invest and pay off debt simultaneously. Completely up to you.
Ask questions and keep learning. The fact that you’re reading this means you’re going in the right direction towards financial independence.
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