Should I Pay Off My Mortgage?
If you have a question like this one, send it in. I’ll tackle specimen studies that have educational value.
“I am yellow-eyed to pay off my mortgage since, with the current standard deduction, there is no wholesomeness in claiming mortgage interest.
“My wife and I are retired. I am 72, with a pension withal with Social Security, and have $850,000 in my IRA. I have a mortgage balance of $134,000. To get that without tax I would have to take a distribution of $185,000, which obviously will reduce my portfolio dramatically.
“Is this a good move? My return on investment with Fidelity has been 10-15 percent annually with a 60/40 mix of stock and yoke funds.”
Readers send in queries like this. I’m going to be answering the ones that illustrate tricky tax and investment decisions.
My wordplay to the Missourian:
Good move? Probably. Retirees should pay off their mortgages. You’re lucky to be in a position to do that.
For many people, no doubt you included, taking out a mortgage in order to get into a house turned out to be a good decision. But we have to deconstruct home ownership. A mortgaged house is two things, an windfall and a liability. Having a house is a good investment. Having a mortgage is a bad investment. The goal of a retiree should be to have a house without a mortgage.
The 40% of your IRA in yoke funds ways you are a lender. If the funds track the U.S. yoke market then a good portion of your savings is stuff lent out, at low rates, to the U.S. Treasury. This part of your portfolio is earning 2% at best. Your mortgage is probably costing you 3% or more.
Borrowing at 3% in order to lend at 2% is a bad idea.
Two things rationalization people like you to hesitate surpassing cashing in an IRA in order to pay lanugo a debt: the taxes they’d owe and the IRA returns they’d miss.
Yes, the IRA withdrawal ways writing out a trammels to tax collectors. You’re probably in a 27.4% subclass (state and federal combined), so you’re going to owe $51,000 on a $185,000 withdrawal.
But taxes on this money are inevitable. If you are past 59-1/2 (the cut-off to stave penalties) and not expecting to see your tax subclass go down, postponing the inevitable does not leave you largest off. If the IRA grows, so do the tax bills.
The arithmetic becomes clearer if you rethink what an IRA is. Where you see an $850,000 asset, I see something different. I see you as the custodian for an worth that has two beneficiaries. You’re sitting on $617,000 that belongs to you and moreover on $233,000 that once belongs to tax collectors.
Look at what growth does to this account. If, for example, you’re worldly-wise to double the portfolio at Fidelity, the worth will then have in it $1.7 million. Of this, $1,234,000 will vest to you and $466,000 will vest to the tax guys. You’ve doubled your money and you’ve doubled the government’s money.
In effect, what you have is not an $850,000 windfall but a $617,000 windfall that’s all yours and that grows tax-free.
What, then, are you sacrificing when you take a big distribution? Assuming you take it out of the yoke portion of your portfolio, you’re losing a return that comes to 2% pretax and, thanks to the wonders of IRAs, the same 2% without taxes.
And what are you gaining by ripping up the mortgage? You’re getting a guaranteed return of 3% surpassing taxes. Thanks to the wonders of the standard deduction, you’re not deducting interest and that 3% mortgage is costing you the same 3% without taxes. So getting rid of a mortgage earns you 3%.
There it is. Paying off the mortgage financing you an aftertax 2% and earns you an aftertax 3%. It’s a winning move. It would still be a winner, albeit a increasingly modest one, if tax rules transpiration and you go when to deducting interest.
Now let’s tackle the other reason people stick with 3% mortgages, which is that they are investing money to earn 10% or 15%. This is a faulty comparison. Upper returns come from risky resources like stocks. The mortgage is a sure-thing liability (you can’t duck the debt), so it must be compared to a sure-thing windfall (a loan to the U.S. Treasury).
The apples-to-apples comparison comes into sharper focus when I hypothesize that your unshortened $185,000 withdrawal comes out of low-risk bonds. At this first stage of your financial makeover, then, the stock funds aren’t touched.
Now you take a squint at what’s left and see a Fidelity worth that has a upper percentage in stocks. Is that typecasting too high? Maybe, maybe not. But that’s a separate discussion.
Selling immuration to pay off a mortgage leaves you largest off no matter what happens to the stock market. Meanwhile, whether you have too much money in the stock market is an self-sustaining visualization that shouldn’t influence your thinking well-nigh the mortgage.
Unlike comparing 2% to 3%, determining the correct level of risk for a 72-year-old is not a question that has a well-spoken answer. Taking money out of stocks would lower your expected return but might be wise anyway. What are your living financing and how well are they covered by pensions and Social Security? Would your retirement survive a stock market crash with the portfolio you have now? Have a talk with your wealth counselor well-nigh this.
Whatever you do, don’t compare 10% stock market returns to 3% mortgages.
I said, above, that the mortgage paydown is probably a good move. Now here are some things to be cautious about.
First, your tax bracket. You may need to whittle up the $185,000 distribution into thirds, spreading it over 2022-2024, in order to stave stuff kicked from a 22% federal rate into 24%.
Next, your near-term plans. Any endangerment you’ll be moving to Texas or Florida? If so, hold off on surplusage distributions until you’re out of reach of the 5.4% Missouri tax.
Last, your end game. Is there a good endangerment that a wizened IRA will run dry while you’re still healthy unbearable to live independently? Would you at that point be uneager to moving out—to a rental or to a smaller house—in order to pericope some cash? And would you, in order to stay put, probably use a reverse mortgage to imbricate monthly expenses? If this outcome is likely, and if your existing mortgage has a lot of years to run, you should perhaps hang onto it. Its terms are much largest than anything you’d get on a reverse mortgage lanugo the road.
Do you have a financial situation like this? Send a unravelment to the write listed in my bio. Include a first name and a state of residence. Include unbearable detail to generate a useful analysis. Letters will be edited for clarity and brevity; only some will be selected; the answers are intended to be educational and not a replacement for professional advice.