Should You Save for Retirement or Pay Off Your Mortgage?

Q:My wife and I are 56 years old and we plan on retiring at age 64. We have good incomes, our kids are now self-supporting, and we would like to hit retirement (in 8 years) with our home paid off. In order to make this happen, we decided to reduce our 401(k) deposits to 6% (from the max), and to take that extra money and apply it to our mortgage payment. Was this wise? -- James

A: Transitioning into retirement with a home paid off is often a good goal. After all, if your retirement expenses are less because there are no more mortgage payments, then the income you’ll need during retirement will be less, as well. Simple, right?

Well, maybe.

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An important part of deciding whether or not this is a wise move revolves around first determining precisely what your income tax situation is. For various reasons, working couples in their mid-50s are often in a higher tax bracket than at any time in the past. There are a lot of reasons for this, but a few important ones are that the kids are gone and are no longer dependents, people in their 50s are often at the height of their earning power, and because the mortgage balance has been paid down, that tax deduction isn’t as high as it once was, either.

If this sounds like you, James, and you have the highest income you’ll ever have, than this may not be the best time to forgo the tax deduction that a 401(k) provides. Looking forward, the odds are good that your tax bite won’t be nearly as bad once you retire.

Now, because the only options you gave me were to either max out your 401(k)s, or to put less in your 401(k)s and pay down the mortgage, I’m assuming there are no other options (such as money sitting in a savings or brokerage account).

If you are in a high-tax bracket right now, I suggest you return to investing the max in your 401(k)s, but consider making this one change: Direct the majority of your deposits into a conservative fund within your 401(k), and earmark these dollars as future mortgage dollars. This provides you with a great savings vehicle to accumulate money to pay off that mortgage. Then, later, once you retire, roll your 401(k)s into two separate IRAs: One will provide retirement income and one will be used to pay the mortgage payment. Depending upon your taxable income during retirement, you may actually be able to accelerate the mortgage payments from the IRA so that your home is paid off within a few short years.

Now, conversely, if your current taxable income is relatively moderate (and you know that it won’t be any lower during retirement), bypassing the tax deduction (of the 401(k)) might not be a bad thing. In fact, if you believe you’ll actually be in a higher tax bracket during retirement, you should not be contributing so heavily to your 401(k). That’s because, why would you want to have less taxable income today, only to pay taxes at a higher rate when you withdraw the money in the future?

But if you estimate that you’ll be in a lower income tax rate during retirement, then I would advise you that maintaining your existing strategy (and paying down the mortgage) is the way to go. True, your 401(k) balances won’t be as high when you hit retirement, but you will no longer have a mortgage because your home will be paid off.

One last thing to keep in mind: for people who reach retirement and their home is not paid off (and there’s still a significant balance), it might actually be best to contact the bank to change your loan to stretch out the payments for as long as possible (even for 30 years). That’s because I’ve seen people who spend their healthiest retirement years not doing the things they dreamed of doing, just so that their mortgage could be paid off, say, 12 years from now on their 77th birthdays. This makes no sense to me. If you can’t pay your house off before you retire, and if there’s a good-sized balance (or loan duration) remaining, then I believe it’s actually better to have as small a mortgage payment as possible so that you’ll have better cash flow today.

Hope that helps, James. Good luck!