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.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free 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.
-
What Dave Ramsey and Caleb Hammer Taught Me About Handling MoneyFrom Ramsey’s strict discipline to Hammer’s blunt reality checks, their lessons reveal how to save, invest and prepare for the future.
-
Dismal August Jobs Report Offers Rate-Cut Relief: What the Experts Are SayingThe August jobs report came in much lower than expected, lifting the odds that several rate cuts will come through by year's end.
-
Greed, Fear and Market Volatility: A Financial Adviser's Guide to Keeping Emotions Out of Investment DecisionsDon't panic! And don't be so confident in the stock market that you overlook risk. Instead, be logical. Your retirement security could depend on it.
-
Want a Financial Adviser Who Shares Your Faith? Look for One With a CKA DesignationFinancial professionals with a Certified Kingdom Advisor certification are committed to integrating biblical principles with sound financial advice.
-
10 Ways to Stay Safe From Grandparent Scams and Other Fraud, Courtesy of a Financial PlannerScams are increasingly hard to detect, and anyone can be fooled, from older people to educated professionals. Here are 10 ways to avoid becoming a victim.
-
This Is How the Student Loan Bubble Is Primed to Pop, From a Student Funding ExpertFueled by easy money, inflated tuition and high default rates, the student loan bubble mirrors the 2008 subprime mortgage crisis. We could be headed for a potential financial collapse. What can we do?
-
More Than Money: The Hidden Toll of Financial Abuse of Older AdultsFinancial abuse from schemes involving tech support, government impostors, false sweepstakes, grandchild hoaxes and online shopping issues can cause thousands of dollars in losses.
-
I'm a Financial Planner: Here Are Three High-Impact Ways to Make a Difference With Your DollarsThe world often feels out of control, but here are three ways to use your money — through investments, charitable giving and political donations — to help create a more just and sustainable future.
-
The Unsung Hero of Aisle 5: A Tale of Forgotten Change and Compassion at the SupermarketThis supermarket manager went above and beyond to help when a child forgot her change at the checkout counter. You might be surprised at some of the complications that supermarkets face when it comes to customers' forgotten change.
-
Train, Integrate, Retain: A Strategic Playbook for Adviser OnboardingsBuild a thriving practice by training new advisers with clear goals, structured processes and consistent mentorship for strong team growth.
