Retirees: Research your mortgage

PHOTO/Chas St. George/For the Journal
kukes.jpg For most people, conventional wisdom supports the idea of paying off the home mortgage before retirement. Therefore, a retiree should be debt free, allowing income from pensions, Social Security and retirement distributions to support living expenses. From an estate standpoint, the home would be transferred to the children free and clear at death.

Could there be reasons for maintaining a mortgage in retirement? Individuals with a large amount in a retirement program, individual retirement account or 401(k) in the form of securities, or paper assets, may want to consider the following:

1) A balanced portfolio of paper assets to hard assets.

2) Potential substantial tax burden imposed on mandated retirement fund withdrawals at age 70 1/2.

3) Life in a beautiful home that could increase the size of an individual’s legacy.

4) The income tax benefits of deductible mortgage interest.

Instead of paying off the mortgage on an existing house, you may consider trading up to a more valuable home or purchasing a second home. The increased mortgage can be covered by an increase in withdrawals from the retirement plan. A recent article on this subject suggested $2 million as a minimum retirement plan to provide for a mortgage payment without diluting value to meet future retirement needs.

The results of this transaction are a shift of capital from paper assets to real estate, retention of a deduction for income tax calculation and an improved lifestyle in retirement.

In addition, by making the purchase before 70 1/2, the increased withdrawals at an earlier age will cause reduced taxes from mandatory distributions, since there will be less money accumulating in the retirement plan from which to draw.

Let’s look at a simple scenario of a retiree at age 65 with $2 million in a retirement plan, and we’ll assume a 6 percent return on the investments in this plan. We’ll call our retiree Joe. Joe trades his house valued at $500,000 for a house costing $1 million and borrows $800,000, with the remainder coming from equity in his current home. The mortgage rate is 7 percent and term is 15 years.

Under this example, Joe would draw the earnings each year, about $86,000 for mortgage payments and $34,000 for living expenses. The first year, he would reduce taxable income of $120,000 by the interest expense of about $55,000. At a 30 percent tax bracket, Joe would save $16,500 excluding all other factors. At 70 1/2, the amount remaining to be drawn from retirement is still $2 million and the remaining estate is in the value of the residence.

If Joe hadn’t purchased the residence as proposed, his retirement nest egg would have compounded to about $2.75 million. Using the same 6 percent formula, Joe will be taxed on $165,000 in distributions vs. about $78,000 in the sixth year, a savings of $26,000 in taxes that year alone.

The argument can be made that Joe would save about $105,000 in taxes if he didn’t draw from his plan since there wouldn’t be income from retirement withdrawals. That savings is only for the 5 1/2 years before 70 1/2, while the tax savings from carrying the mortgage for the next five years would be about $128,000 and savings would continue until death or repayment of the mortgage.

Of course, this simple scenario about Joe, while interesting and may result in some thinking about the options, isn’t complete. All factors in a financial decision like purchasing a more expensive home need to be considered before spending the money. They include:

  • Does the real estate fit well in Joe’s portfolio?
  • Are there other tax issues like other earnings or other deductibles?
  • Will Joe be in a different tax bracket during retirement?
  • Does the investment portfolio support the decision?
  • Does Joe want an expensive home to live in?
  • What would be the consequences of pulling retirement funds and paying off the existing mortgage vs. maintaining the existing home and mortgage?
  • Would Joe be better off purchasing a second home?

Before planning to retire without a home mortgage, consider the scenario of Joe and the potential advantages in purchasing a larger home, retaining a mortgage on the existing home or mortgaging a second home. If you are unsure, check with your accountant or a certified financial planner.

Ron Kukes is president and chief executive of First Interstate Bank of Alaska. He can be reached via e-mail at ([email protected]).

11/04/2001 - 8:00pm