Q: I will retire in 18 months and my husband and I feel that we are well prepared financially. We have about $2 million in our IRAs and 401(k)s, plus a pension. I would really like to pay off the $500,000 mortgage on our house. The interest rate is only 4.5%, but we would feel better if we could get rid of our monthly payments. How can I use my retirement savings to pay off the house? We don’t have much savings outside of these accounts.
A: It would seem reasonable to simply take some retirement savings and use it to pay off your home mortgage. The challenge, however, is that your retirement accounts don’t only belong to you. You have the taxman as your silent partner.
You’ve certainly done a nice job accumulating money in your 401(k)s and IRAs, and while it’s tempting to view the money as yours do to with as you please, unfortunately, none of these dollars have been taxed. This is, of course, because you received a tax-deduction on the money you contributed to the accounts, and all of these earnings have grown tax-deferred.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
The good news is that the level of tax that you’ll pay on your retirement savings is, at least in part, up to you. By that I mean that you have some control over how much in income taxes you’ll owe based upon how much you withdraw in any one year.
The U.S. income tax structure is highly progressive, so that the more income you have in any one year, the higher your marginal tax rate. For those with low income, the standard deduction and personal exemption will eliminate any income taxes, so their rate is essentially zero. However, for those at the high end of the income range, the top federal tax rate is 39.6%, plus another 3.8% on investment income for Obamacare. (Additionally, if you reside in a state with high income taxes, you can add on another 10%, give or take.)
Worst scenario? If you pulled money out of your retirement accounts to pay off the $500,000, by the time you paid off both the mortgage and the income taxes, it could cost you about $900,000.
By my calculations, the total interest costs for your loan for this year will be about $22,500 (4.5% times your mortgage balance of $500,000). This might sound like a lot, but it’s nothing compared to the roughly $400,000 you would owe the taxman if you attempted to pay off your house in a single year.
One method to reduce the tax burden would be to pay off your home over a few calendar years. For example, pay $166,000 per year for the next three years. To be clear, while this would certainly shrink your income tax bill, it would still cost you much more than the interest rate you are paying.
Because you’d like to eliminate your mortgage payment, here’s what I suggest you do: Set up a separate IRA and move $500,000 into it. Think of this as your “mortgage IRA.” Invest these dollars somewhat conservatively, and then establish a monthly withdrawal that is equal to your mortgage payment. Each month, right before your mortgage payment is due, you’ll have a deposit from your “mortgage IRA” that will be the same amount as your house payment.
Your monthly withdrawal from your IRA will be treated as taxable income, but you’ll be receiving a tax deduction for the majority of your mortgage payment, essentially eliminating the income tax consequences. You will trigger a small amount in taxes, but it will be insignificant, particularly for the next several years.
If you like the sound of this strategy, then make sure you have a long mortgage. If your mortgage is a 15-year loan, you might consider swapping it out for a 30-year, or maybe even a 40-year mortgage. The goal here is not to pay off the mortgage balance as quickly as possible, but to keep the mortgage payment as low as possible.
A couple items to keep in mind: First, if you had amassed $2 million in savings that had already been taxed, paying off your home would be simple and probably advisable. Many retirees like the idea of having their house debt-free. Second, it’s important that you invest this “mortgage IRA” in a manner that will produce a high degree of confidence that it will generate enough of a return to make the monthly withdrawals, but without taking on unnecessary risk.
Scott Hanson, CFP, answers your questions on a variety of topics and also co-hosts a weekly call-in radio program. Visit MoneyMatters.com to ask a question or to hear his show. Follow him on Twitter at @scotthansoncfp.
-
Seven Steps Couples Should Take Before Blending Their FinancesGetting on the same page now can ensure you remain successful throughout your relationship.
-
Charitable Remainder Trust: The Stretch IRA AlternativeThe SECURE Act killed the stretch IRA, but a properly constructed charitable remainder trust can deliver similar benefits, with some caveats.
-
Charitable Remainder Trust: The Stretch IRA Alternative
The SECURE Act killed the stretch IRA, but a properly constructed charitable remainder trust can deliver similar benefits, with some caveats.
-
Three Ways to Take Control of Your Money During Financial Literacy MonthBudgeting, building an emergency fund and taking advantage of a multitude of workplace benefits can get you on track and keep you there.
-
How Did O.J. Simpson Avoid Paying the Brown and Goldman Families?And now that he’s died, will the families of Nicole Brown Simpson and Ron Goldman be able to collect on the 1997 civil judgment?
-
What Not to Do if an Employee or Loved One Is KidnappedBusinesses need to have a crisis plan in place so that everyone knows what to do and how to do it. Sometimes, calling the authorities isn’t recommended.
-
Why You Shouldn’t Let High Interest Rates Seduce YouWhile increased interest rates are improving the returns on high-yield savings accounts, that may not be an effective place to park your money for the long term.
-
Need to Build an Emergency Fund? Seven Steps to Get ThereHaving a safety net can mean peace of mind on top of being able to maintain your lifestyle if a financial emergency strikes.
-
Which Type of Life Insurance Is Right for You?Life insurance isn’t a one-size-fits-all option. Here are the differences between term life, whole life and indexed universal life insurance.
-
What Happens Financially When You Work One More Year?The impact of saving more, spending less later and benefiting from an extra year or more of compounding can be truly staggering.
