Should I Pay Off My Mortgage?

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If you have a question like this, send it in. I would look at case studies that have educational value.

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“I’m looking forward to paying off my mortgage, because with the current standard deduction, there’s no point in claiming mortgage interest.

“My wife and I are retired. I’m 72 years old, with a pension with Social Security, and $850,000 in my IRA. I have a mortgage balance of $134,000. To get it after tax, I have to pay $185,000 Dollars would have to be disbursed, which obviously would shrink my portfolio dramatically.

“Is this a good move? My return on investment with Fidelity has been 10-15% p.a. with a mix of 60/40 stock and bond funds.”

Michael, Missouri

Readers send questions like this. I’m going to answer those reflecting on difficult tax and investment decisions.

My answer to Missouri:

good move? Maybe. Retirees must pay off their mortgage. You are lucky to be in a position to do so.

For many people, there is no doubt that you have made a good decision to take out a mortgage to enter a home. But we have to rebuild home ownership. A mortgaged house is two things, an asset and a liability. Having a home is a good investment. Pledging is a bad investment. A retiree should aim to have a home without mortgage.

40% of your IRA in bond funds means you are a lender. If the funds track the US bond market, a good portion of your savings is being lent to the US Treasury at lower rates. This part of your portfolio is earning 2% at best. Your mortgage is probably costing you 3% or more.

Borrowing at 3% to lend at 2% is a bad idea.

Two things cause people like you to hesitate before cashing in an IRA to pay off debt: the taxes they’ll have to pay and the IRA returns they’ll miss.

Yes, IRA withdrawals mean writing checks to tax collectors. You’re probably in the 27.4% bracket (state and federal combined), so you’ll have to pay $51,000 on a $185,000 withdrawal.

But taxes on this money are inevitable. If you’ve passed 59-1/2 (the cut-off to avoid penalties) and aren’t expecting your tax bracket to go down, it’s better not to postpone the inevitable. If the IRA grows, so do the tax bills.

If you reconsider what an IRA is, the arithmetic becomes clear. Where you look at the $850,000 property, I see something different. I see you as the custodian of the account which has two beneficiaries. You are sitting on $617,000 which is yours and also on $233,000 which already belongs to tax collectors.

See what growth does to this account. If, for example, you were able to double the portfolio at Fidelity, you would have $1.7 million in the account. Of this, $1,234,000 will be yours and $466,000 will be taxed. You have doubled your money and you have doubled the government’s money.

In fact, what you have is not an $850,000 asset, but a $617,000 asset that is entirely yours and grows tax-free.

So, what are you giving up when you take a large distribution? Assuming you take it out of the bond portion of your portfolio, you’re missing out on a return that comes to 2% pretax and, thanks to the wonders of IRAs, the same 2% after taxes.

And what are you gaining by ripping off the mortgage? You are getting guaranteed return of 3% before tax. Thanks to the wonders of the standard deduction, you’re not deducting interest and the 3% mortgage is costing you the same 3% after taxes. So getting rid of a mortgage earns you 3%.

There is. Paying off the mortgage costs you 2% after-tax and you get 3% after-tax. This is a winning move. If the tax rules change and you go back to deducting interest it will still be a winner, although it will be more modest.

Now let’s deal with the second reason why people stick with 3% mortgages, which is that they are investing money to earn 10% or 15%. This is a faulty comparison. Risky assets like stocks give high returns. A mortgage is a fixed obligation (you cannot reduce the debt), so it should be compared to a fixed asset (a loan to the U.S. Treasury).

The apples-to-apples comparison comes to mind more when I assume that your entire $185,000 withdrawal comes out of low-risk bonds. In this first phase of your financial turnaround, stock funds are not touched.

Now you can see what’s left and look for a Fidelity account that has a high percentage of the stock. Is that allocation too high? maybe maybe not. But that is a different discussion.

Selling bonds to pay off a mortgage leaves you better off no matter what happens in the stock market. In the meantime, whether you have too much money in the stock market is an independent decision that should not affect your thinking about mortgages.

Unlike comparing 2% to 3%, determining the right level of risk for a 72-year-old is not a question that has a clear answer. Withdrawing money from stocks will lower your expected return but may still make sense. What are your costs of living and how well are they covered by pensions and Social Security? Will your retirement survive a stock market crash with the portfolio you have now? Talk to your wealth advisor about this.

Whatever you do, don’t compare a 10% stock market return to a 3% mortgage.

I said above, that the mortgage payment is Maybe a good move. Now here are some things to be careful of.

First, your tax bracket. To avoid kicking in the 24% to 22% federal rate, you may need to spread the distribution of $185,000 over 2022-2024.

Next, your near-term plans. Any chance you’re going to Texas or Florida? If so, withhold additional distributions until you are beyond the reach of the 5.4% Missouri tax.

Last, your final game. Is there a good chance that a small IRA will dry up when you’re healthy enough to live independently? Would you be against renting or moving into a tiny house just to pull out some cash at the time? And would you, to stay afloat, probably use a reverse mortgage to cover monthly expenses? If this is likely to result, and if your existing mortgage has a lot of years to run, you should probably get the hang of it. Its terms are much better than anything you’ll find on a reverse mortgage down the road.

Do you have such financial situation? Send details to the address listed in my bio. Include first name and state of residence. Include enough detail to generate useful analysis. Letters will be edited for clarity and brevity; Only a few will be selected; Answers are intended to be educational and not in place of professional advice.


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