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.
-
8 Rules for Choosing the Right Financial AdviserNot all advisers are created equal. Here's how to find one qualified to manage your wealth and protect your legacy. From verifying credentials to trusting your gut, follow these rules to find a financial adviser.
-
A Hated TSA Rule Was Finally Phased OutAfter nearly 20 years, the TSA is ending its shoes-off policy. Travelers will still need a Real ID, and advanced screening remains in place. Here’s what to expect on your next flight.
-
Financial Fact vs Fiction: Why Your 'Magic Number' Isn't Actually MagicalDo you think you're diversified if you're invested in the S&P 500 and Nasdaq? Do you think your tax rate will fall in retirement? Think again — and read on for other myths that could be leading you astray.
-
Opportunity Zones: An Expert Guide to the Changes in the One Big Beautiful BillThe law makes opportunity zones permanent, creates enhanced tax benefits for rural investments and opens up new strategies for investors to combine community development with significant tax advantages.
-
Five Ways Retirees Can Keep Perspective Through Market JittersMarket volatility is a recurring event with historical precedents (the dot-com bubble, global financial crisis and pandemic), each followed by recovery. Here's how people who are near or in retirement can navigate economic uncertainty.
-
I'm a Financial Strategist: This Is the Investment Trap That Keeps Smart Investors on the SidelinesForget FOMO. FOGI — Fear of Getting In — is the feeling you need to learn how to manage so you don't miss out on future investment gains.
-
Can You Be a Good Parent to an Only Child When You're Also a Business Owner?Author and social psychologist Susan Newman offers advice to business-owner parents on how to raise a well-adjusted single child by avoiding overcompensation and encouraging chores.
-
How Advisers Can Steer Their Clients Through Market Volatility (and Strengthen Their Relationships)Financial advisers need to be strategic when they communicate with clients during market volatility. The goal is to not only reassure them but to also help them avoid rash decisions, deepen your relationship with them and build lasting trust.
-
The Hidden Costs of Caregiving: Crisis Goes Well Beyond Financial IssuesMany caregivers are drained emotionally as well as financially, leading to depression, burnout and depleted retirement prospects. What's to be done?
-
Cash Balance Plans: An Expert Guide to the High Earner's Secret Weapon for RetirementCash balance plans offer business owners and high-income professionals a powerful way to significantly boost retirement savings and reduce taxes.
