Q: I recently got out from under a fairly good-sized monthly expense, and I’m ready to move on to some of my standing debt. Is it better to pay off highest-interest debt first, or the small owed amount first? — Scott (via Facebook)
A: Scott, the rationale that I’ve heard for paying off the smallest debt first is largely psychological. It demonstrates to you that you’re making progress. It creates some momentum. It gets you excited about this new chapter in your financial life. And certainly, if that is what works for you, I wouldn’t want to tell you to do otherwise.
The answer to your question really comes down to what motivates you. If seeing financial obligations starting to drop off of your household budget gets you going, then paying off the smallest balance first makes more sense. On the other hand, if you’re someone who is able to internalize that you’re saving more money, albeit much more incrementally, then starting with the higher-interest balances first makes more sense.
This is a great example of the differences that human beings have in their relationships with finances. Scott, neither of the options is wrong or bad. They both move you forward in a positive financial direction. They do so in slightly different ways, but both are good. And whichever one keeps your motivation stronger to continue along that path is a good option.
Q: I’ve been reading-up on 401k’s and IRA’s, and I want to pursue both. But which one should I start with? — Heather (via email)
A: Heather, I do talk a lot about these retirement accounts, their features, and the various pros and cons of each, but I don’t think we’ve ever really explored which is better for the initial foray. Thanks so much for the question!
If it were me, I would start with a 401k for one very simple reason…your employer match. This is free money that your employer is handing to you, and that is not something to be missed. The only wrinkle there will be that (sadly) not every employer offers a company match to their 401k. If that happens to be the case for you, then the central issue actually comes down to your view on taxes. Specifically, do you expect your tax rate to increase or decrease in the future?
If you believe that your taxes are going to go up in the future, you’ll want to go into a Roth product. And between 1997 to 2006, that meant a Roth IRA. That would be the end of my answer if it weren’t for the fact that 2006 saw the first use of a Roth 401k.
The reason that you want a Roth if you expect your tax rate to go up in the future is that Roth products are taxed today so that the proceeds can be withdrawn tax-free down the road. Not only are you betting that you’re paying a lower tax rate now, but you’re probably also considering the fact that you’re paying those taxes now while you have an income, instead of after retirement when you’re no longer working.
Conversely, if you expect your tax rate to be lower in the future than it is today, consider a traditional product. And yes, you guessed it…there are traditional IRA’s and traditional 401k’s, as well. There are always more variables than you think, aren’t there?
If you’re not offered a company match anyway, then you may as well look at an IRA instead; again, letting your views on the future of taxes guide your decision on Roth vs traditional. IRA’s give you more flexibility on investment options, though with a lower annual investment amount.
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— Eric Litwiller has spent the last eight years of his professional career helping people achieve their financial goals through the use of budgets, retirement vehicles, and estate planning options. He is a firm believer in the importance of using Earthly riches to fulfill a mission of Christian stewardship. Eric is not a licensed financial planner.