Do I have to pay off my mortgage?

If you have a question like this, send it. I will discuss case studies that have educational value.

“I can’t wait to pay off my mortgage because, with the current standard deduction, there is no benefit to claiming mortgage interest.

“My wife and I are retired. I am 72 years old, I have a pension with Social Security and I have $ 850,000 in my IRA. I have a mortgage balance of $ 134,000. To get this after tax, I would have to receive a distribution of $ 185,000, which obviously will significantly reduce my portfolio.

“Is this a good shot? My return on investment with Fidelity has been 10-15% per year with a 60/40 mix of equity and bond funds.

Michel, Missouri

Readers send requests like this. I will respond to those that illustrate difficult tax and investment decisions.

My response to the Missourian:

Good move? Probably. Retirees should pay off their mortgages. You are lucky to be able to do this.

For many people, arguably including, taking out a mortgage to move into a home has turned out to be the right decision. But we need to deconstruct home ownership. A mortgaged home is two things, an asset 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 home without a mortgage.

The 40% of your IRA in bond funds means you are a lender. If funds follow the US bond market, a good chunk of your savings is loaned, at low rates, to the US Treasury. This part of your portfolio earns 2% at best. Your mortgage is probably costing you 3% or more.

Borrowing at 3% to lend at 2% is a bad idea.

Two things make people like you hesitate before cashing in an IRA to pay off a debt: the taxes they owe and the IRA returns they would miss.

Yes, the IRA withdrawal means writing a check to the collectors. You’re probably in a 27.4% range (state and federal combined), so you’re going to owe $ 51,000 on a $ 185,000 withdrawal.

But taxes on that money are inevitable. If you’ve passed 59-1 / 2 (the threshold to avoid penalties) and don’t expect your tax bracket to drop, postponing the inevitable doesn’t leave you better. If the IRA grows, so do the tax bills.

The arithmetic becomes clearer if you rethink what an IRA is. Where you see an asset of $ 850,000, I see something different. I see you as the custodian of an account that has two beneficiaries. You are sitting on $ 617,000 which belongs to you and also on $ 233,000 which already belongs to the collectors.

Watch what the growth does to this account. If, for example, you manage to double the portfolio at Fidelity, then the account will contain $ 1.7 million. Of this amount, $ 1,234,000 will belong to you and $ 466,000 will belong to tax professionals. You doubled your money and you doubled the government money.

Indeed, what you have is not an asset of $ 850,000, but an asset of $ 617,000 which belongs to you and which grows tax-free.

What do you sacrifice then when you take a big distribution? Assuming you take it out of the bond portion of your portfolio, you lose a 2% pre-tax return and, thanks to the wonders of IRAs, the same 2% after-tax.

And what do you gain by tearing up the mortgage? You get a guaranteed return of 3% before taxes. Thanks to the wonders of the standard deduction, you don’t deduct interest and that 3% mortgage is costing you the same 3% after tax. So getting rid of a mortgage pays you 3%.

Here it is. Paying off the mortgage costs you 2% after tax and earns you 3% after tax. It’s a winning shot. It would still be a winner, albeit more modest, if the tax rules changed and you came back to deducting interest.

Now let’s take a look at the other reason people stick with 3% mortgages, which is that they invest money to earn 10% or 15%. This is a false comparison. High returns come from risky assets like stocks. The mortgage is a safe liability (you can’t dodge the debt), so it should be compared to a safe asset (a loan to the US Treasury).

The apples-to-apples comparison becomes clearer when I assume that your entire $ 185,000 withdrawal is from low risk bonds. At this first stage of your financial makeover, equity funds are therefore not affected.

Now you look at what’s left and see a Fidelity account that has a high percentage of stocks. Is this allowance too high? Maybe, maybe not. But this is a separate discussion.

Selling bonds to pay off a mortgage leaves you better off no matter what happens to the stock market. In the meantime, whether you have too much money in the stock market is an independent decision that shouldn’t influence your thinking about the mortgage.

Unlike the comparison of 2% to 3%, determining the correct level of risk for a 72-year-old is not a question that has a clear answer. Withdrawing money from stocks would lower your expected return, but might be wise anyway. What are your living expenses and to what extent are they covered by pensions and social security? Would your retirement survive a stock market crash with the portfolio you currently own? Discuss it with your wealth advisor.

Whatever you do, don’t compare 10% stock returns to 3% mortgages.

I said above that the mortgage repayment is Probably a good hit. Here are some points to be careful about.

First, your tax bracket. You may need to split the $ 185,000 distribution into thirds, spreading it over 2022-2024, in order to avoid being kicked out of a federal rate of 22% to 24%.

Then your short term plans. Do you have a chance to relocate to Texas or Florida? If so, suspend excess distributions until you are out of range of the 5.4% Missouri tax.

Finally, your end of the game. Is there a good chance that a decreased ARI will burn out while you are still healthy enough to live independently? Would you be opposed at that point to moving – to a rental or to a smaller house – in order to extract money? And to stay put, would you likely use a reverse mortgage to cover your monthly expenses? If that outcome is likely, and your current mortgage has many years to go, then you might want to hang in there. Its terms are much better than anything you would get down the road with a reverse mortgage.

Do you have a financial situation like this? Send a description to williambaldwinfinance — at — gmail — dot — com. Put “Request” in the subject field. Include a first name and state of residence. Include enough detail to generate a useful analysis.

Letters will be edited for clarity and conciseness; only some will be selected; Answers are intended to be educational and do not replace professional advice.

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