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Should You Save for Retirement or Pay Off Credit Card Debt?

"Should I pay off my credit card debt or use the money to save for retirement?" I hear this question frequently from people in their 20s and 30s, and it's a good follow-up question to my earlier post, Retirement Planning Advice for My 20-Something Son.

Some people even have a budget for their savings: "I can save $5,000 this year, so how should I prioritize my savings goals?" My first thought is, if you think you can save $5,000 per year, figure out how to save $6,000! I contend that most people can save more than they think they can by taking a hard look at their spending habits. Most people don't have enough money to meet all their savings needs, so you'll meet your goals faster if you can figure out how to save more.

Having said that, let's address some guidelines for prioritizing your savings depending on the choices you might face.

First, save enough to build up an emergency fund that equals your living expenses for three to six months. This is just in case you get laid off from your job or have a medical emergency. If you're in a declining industry or have a job that's hard to replace, you might want to put away a larger emergency fund -- one that could last up to 12 months.

Second, put money in your 401k plan if there's a matching contribution from your employer of 50 percent or more. Some people might argue that you're better off paying down credit card debt next, but the 50 percent immediate return on your contributions through an employer match is a higher number than the interest rate charged on most credit cards. So I'd contribute whatever it took to be subject to a matching contribution of 50 percent or more from your employer.

Third, pay off your credit card debt. Actually, I'd prefer you pay off your credit card debt and contribute to your 401k plan when there's a 50 percent match. So you should figure out how to do both -- easier said than done, I know.

Fourth, start building a fund for a down payment on a house, if that makes sense given your personal situation. Factors to consider are whether you expect to stay in the house for five years or more, and whether housing is a good investment in the geographical area where you live. There can be a good financial argument for renting a home instead of buying, so think this issue through given your circumstances before committing to saving for a down payment. One valuable resource to help you make this decision is an online calculator that can help you do the math on "buy vs. rent" decision.

Fifth, increase your 401k contribution until the total contribution, including the employer match, equals 10 percent of your pay, for the reasons mentioned in my prior post.

Sixth, start a 529 plan to pay college tuition for your children. Target an amount that could finance four years at a good public school.

Notice that I haven't yet mentioned paying off any student loans you might have. The reason is, the minimum amount is usually fixed and you don't have a choice about how much you're required to pay on a monthly basis. So I'm assuming the total amount you have available to save is the total after you've made your minimum student loan debt payment. And if you're thinking about paying more than the minimum amount on your student loan, I'd say no; the interest rate charged on most student loans is very low -- lower than the returns you might expect in your 401k plan. So I'd only pay off your student loan debt faster if you've already covered all the saving goals listed above and you have money left over.

And if you have still more money left over to save -- congratulations! In this case, you should make additional contributions to your 401k plan until you've hit the legal maximum.

It's well worth spending some time thinking through these priorities and committing to a program of saving to meet your various life goals. You'll gain control over your financial life, which will give you many more options in the years to come. It's your ticket to personal and financial freedom.

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