Should You Keep Your Mortgage In Retirement – Does It Make Sense Or Is It A Boondoggle?
Should You Keep Your Mortgage In Retirement – Does It Make Sense Or Is It A Boondoggle?
Decrease taxes? Mortgage payments could increase taxes in retirement!
The tax benefits of a mortgage have been pounded into our heads. Yet most people have no idea what if any benefit they receive from their mortgage interest. The IRS reports that over 70% of taxpayers do not need to file a Schedule A which is where the deduction is claimed. Have your taxes calculated with and without the mortgage interest. Unless you have exceptionally high income or substantial other deductions you might be shocked by the results! The next question to answer for retirees is does the mortgage actually increase my taxes.
The concept of investing in the markets vs. paying the mortgage is irresistible. After all, the interest is deductible. Does the money stay invested? Spent money does not grow! Paying off the mortgage will provide the guaranteed return equal to the mortgage interest rate. There, I said it; even if you don’t agree. Now on to the business at hand, should a retiree hold a mortgage?
In retirement, cash flow is king. Eliminate the costs of payroll taxes, retirement plan contributions, debt service and other expenses resulting from our employment income. The money actually spent on lifestyle might surprise you – by how little it is.
Retirement income is derived from pensions, social security and distributions from investments. A comprehensive financial plan could identify strategies that could make your money last longer while keeping your desired lifestyle. Yes, I said desired lifestyle.
As an example, let’s assume a couple age 62 has $300k in retirement plans, $85k in other accounts and a mortgage of $60,000. Monthly retirement income includes $1,500 of social security benefits and a pension of $2,000. Without considering income taxes they have monthly expenses of $4,800 per month. This consists of $3,800 of lifestyle expenses and $1,000 per month for the mortgage payment.
Their income of $3,500 per month must be augmented by distributions from assets sufficient to cover the $1,300 shortfall and any income tax liability. With the available data we can calculate annual IRA distributions of $24k are required to cover the $1,300 plus income taxes of $8,300. This places this client in the 15% tax bracket. The distributions of 24k equate to an aggressive distribution rate of 8%.
One potential planning strategy could be to eliminate the mortgage. Paying off the mortgage does not reduce net worth. But it will reduce the cash flow required to sustain the client’s desired lifestyle from $4,800 to $3,800. If the net reduction of cash flow is $1,000 per month, by how much should one assume the IRA distributions can then be reduced?
Logically, one would think that the IRA distributions will be reduced by $1,000 per month plus 15-20% for taxes. Well, this would be wrong as we are not using regular logic, we are using IRS logic!
IRS rules require distributions from an IRA to be claimed as income, even to pay income taxes. As taxes are reduced, IRA distributions can also be reduced. In this example the total IRA distributions can be reduced from $24k to $6k. Yes, the last $12k of spendable income has a tax liability of $6,000! Even with this IRA reduction of $18k the cash flow is still $3,800 per month, net of taxes!
Comprehensive financial planning identified a simple adjustment in net worth that provides an immediate tax saving benefit of $6,000 per year. All cost of mortgage interest is immediately eliminated, also. The only thing left to consider is the lost opportunity of investing the funds that were used to pay off the mortgage.
When interest and income taxes are considered, the combined savings of this strategy is $9k per year. The $60k used to pay off the mortgage would require an investment with a guaranteed rate of return of 15% net of taxes to out perform this planning strategy. Remember this is not an investment, but a repositioning of assets. Your benefit is guaranteed by the mortgage interest and income tax savings.
Cash flow, income taxes, net worth and goals (CING™) are different for each family. One family will benefit with this strategy while another may not. This can only be discovered through the comprehensive financial planning with a qualified advisor. Alternate strategies could be more beneficial depending on the unique personal finances of each household. Seek the advice of a qualified NAPFA registered fee only planner to find the best strategy for you.
Roger C. Kruse, ChFC, CFP® is a NAPFA registered FEE ONLY® financial advisor and a principal and co-founder of FFP Wealth Management, a registered investment advisory firm located in Coon Rapids, Minnesota. Roger has over 17 years of comprehensive financial planning experience with a focus on the investment and financial planning needs of retiring or retired clients. FFP Wealth Management has approximately $70 million of client assets under management. Learn more at http://www.ffpwealthmanagement.com