Should I Pay Off Debt Before I Retire?

Key Takeaways

• Consider emotional and financial implications of debt in retirement.
• Prioritize high-interest debt; low-cost loans may be manageable.
• Balance paying off debt with investing for better long-term outcomes.
• Tax advantages and other strategies impact debt management decisions.

You'll probably want to eliminate any debt with high interest rates beforehand. But the decision to wipe out other types of debt, such as a mortgage, depends on your personal situation. It may feel like a sensible move, but reducing debt too aggressively can sometimes leave you in a worse financial situation.

Here's what to consider when deciding to pay off your debts pre-retirement, as well as insight into how much you should save for retirement.

Do You Need to Be Debt-Free in Retirement?

Choosing to pay off debt is an important financial decision and one with strong psychological implications. Some retirees rest easier at night knowing they don't have extra bills to take care of every month. For them, it's less about dollars and cents and more about the emotional benefit of having little to no debt.

However, that doesn't mean you should ignore the financial side of the equation. Paying down certain debts to the detriment of your investment accounts, for example, can create more emotional strain in the long run. So before you put all your money toward debt, it's important to consider how much you should save for retirement.

In general, paying off high-interest debt, including credit cards, can improve your financial situation. But it may be better to continue relatively low-cost loans, such as home loans, as long as you have sufficient income to make your payments. Sorting out the types of debts you have can help guide your retirement-planning options.

How Can You Prioritize Your Debts?

One of the best ways to prepare for retirement is to avoid taking on new debt. This is especially true if you expect your income to decline when you leave your full-time job. If you have some money to pay off outstanding loans, you might think about starting with the one that has the highest interest rate, then the next highest rate and so on.

Here's a hypothetical example of the order in which you may want to pay off debt (though interest rates vary from borrower to borrower):

• Credit cards
• Other unsecured loans (e.g., personal loans)
• Auto loans
• Student loans
• Mortgages

If you expect paying off your credit cards and other expensive debt could take months or even years, consolidating those obligations into a lower-cost loan may help reduce your monthly payments and overall interest payments. Homeowners may also have the option to pay down credit cards with a home equity loan, which typically has a much lower rate.

Alternatively, you can apply for a credit card with a 0% introductory rate. But understand the risks before you do: If you don't pay off the entire balance once that initial window ends, the regular interest rate will likely kick in. Plus, you may find yourself needing to resist the temptation to make additional purchases on the new card.

What Trade-Offs Might You Consider?

The reason paying off lower-cost loans may not make as much financial sense is because there's an opportunity cost for the money you'd use for those payoffs. Consider the benefit of putting those same dollars toward a different use that could, in the comparative long run, leave you with more money.

Making the most of your money

A simple example is contributing extra income to a 401(k) or individual retirement account (IRA) instead of zeroing out your loan balance. If you reasonably expect those dollars to generate a larger after-tax return in a 401(k) or IRA than you're being charged by your lender, you may want to invest instead.

Here's an example: Suppose you have a portfolio mix of stocks and bonds as you near your retirement that you expect will yield an average 5% annual return. Using money that you might put into that to instead pay down a 4% interest annual loan — depending on your whole financial picture — likely wouldn't be the optimal use of your money.

Factoring in tax advantages

Consider also that some forms of debt have tax advantages. In those cases, the effective rate you're paying ends up being less than the stated interest rate. Mortgages are a notable example. If you itemize your 2023 taxes, you can typically deduct interest on the first $750,000 of debt if you're a joint filer or $375,000 if you file a separate return.¹ Let's say you have a marginal income tax rate of 24%; a 4% interest rate on your mortgage, then, may really cost you closer to 3% when factoring in tax benefits.

The same principle comes into play when deciding whether or not to accelerate payments on student loan debt. Those who meet IRS income guidelines can deduct up to $2,500 of interest on student loans, which means they will potentially pay less than the stated interest rate.² Someone in a 24% income tax bracket with a 6% rate student loan, for example, is effectively only paying 4.56% interest on it.

How you acquire the funds to pay off your loans is another important factor to consider. In some cases, making a large withdrawal from your non-Roth IRA retirement accounts could push you into a higher tax bracket. That only increases the opportunity cost of using those funds to shrink your debt load.