Pay off debt first.

I recently talked to a small, progressive business owner, call her Susan, in Eugene Oregon.  Business was going well, and she felt she and her partner could start saving for retirement.  She wanted advice on how to set up an SEP, and wanted to be sure that the money was invested in a socially responsible way.

I told her to forget about the SEP and start paying off the home equity loan she’d used to fund her business, despite the fact that she would be giving up the tax advantages of the retirement account, and the mortgage tax deduction on the interest she was paying. 

Let’s run the numbers.  Suppose she has $10,000 of pre-tax income she and her partner can invest in an SEP or use to pay down her home equity loan, and she’s in a 22.5% tax bracket.  The interest rate on the loan is 9%.  If she puts the money in the SEP, she won’t owe any tax on it, but she will have to pay tax on the money and any earnings when it comes out.  She puts the money in a socially responsible mutual fund with an expense ratio of 2.66%.  For those of us used to index funds and ETFs (expense ratios often around 0.5%) this seems extreme, but this is a real, socially responsible mutual fund.  I could have also chosen the Class A (load) version of the same fund, but the comparison I’m about to do would make the class A shares look even worse. Her other option is to take the $10,000 and pay down her home equity loan, after paying taxes of $2,250.  Suppose there are 3 possible scenarios for the assets the fund is invested in: down 10%, up 10%, or up 30% over a period of two years. 

Here is where Susan would be after two years in each of these scenarios:

  Pay back loan SEP, -10% SEP, +10% SEP, +30%
Amount invested $7,750 $10,000 $10,000 $10,000
Gain over 2 years $1,458 -$1,000 $1,000 $3,000
Loss of tax deduction -$328      
Fund Expenses   -$505 -$559 -$612
Taxes owed when money will be withdrawn   -$1,911 -$2,349 -$2,787
Net value to Susan $8,880 $6,584 $8,092 $9,601

If Susan opens the SEP, it will look like she has more money in all but the worst scenario above, when the stock market loses 10% over two years.  As we know, a 10% loss over two years is very possible; many mutual funds lost 30% to 70% between 2000 and 2002.  Even the moderate gain of +10% over two years is wiped out if you consider the fact that money in a retirement account is taxable when withdrawn, not even considering the penalty if it is withdrawn early.  

Paying back loans is the best investment most of us can make.  Only if the interest rate on the loan is very low (how low depends on how much risk tolerance you have) does it make sense to invest in the stock market before you pay back debt. 

If you are considering putting money in a CD or bond fund, the comparison looks even worse, because the relatively stable returns of these types of investments usually look like the second scenario above, where the market went up a moderate amount. 

An added bonus for Susan: She knows her money is socially responsible, because it is helping a small, progressive business owner who makes eco-friendly products.   Social responsibility starts at home.


  1. Greg Moore said

    If Susan has any additional debt — a remaining first mortgage on her home, car notes, student loans, credit cards — she may also consider aggressively paying off these debts while business is good and before retirement investing. Typical time frames for aggressively eliminating household debt are 5 – 7 years. The result is she’s positioned her business to survive when times are lean since personal living expenses drawn from the business are cut virtually in half. As an added benefit, successful retirement investing becomes much more likely. She has more money to invest, requires a much smaller nest egg, and may not need the investment returns and risk associated with the stock market.

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