Financial Tip: Pay off all debt, including the mortgage, prior to retirement. This requires planning, the use of 15-year mortgages on the last purchased home, and prioritization of debt payments over additional contributions to 401(k) plans.
Discussion: According to CNBC, experts differ on whether you should retire mortgage debt in retirement. My view is that the retirement of debt in retirement is too little too late. Mortgage debt has to be eliminated prior to retirement to reduce taxes and the risk of outliving your resources.
The goal of mortgage elimination prior to retirement is most important for people with most or all of their wealth inside a conventional retirement account because funds disbursed from 401(k) plans are taxed as ordinary income. People with a mortgage and all funds in a 401(k) plan must disburse funds to cover the mortgage payment and tax on the disbursement. Moreover, the increase in reported income from the larger 401(k) disbursements will subject a greater portion of Social Security income to tax. (A portion of Social Security income is subject to federal income tax for single individuals for income starting at $25,000 and for married individuals for income at $34,000.)
The elimination of all mortgage debt prior to retirement requires some financial planning. The goal could be achieved by the selection of a shorter-term mortgage for the final home purchase, refinancing from a long-term to short term mortgage, or by making additional payments towards the mortgage when nearing the end of your career. A person over the age of 50 should, at a minimum, prioritize additional mortgage payments over catch-up contributions to 401(k) plans in order to meet this goal. The worker might even consider further reductions in 401(k) contributions to eliminate the mortgage.
Action must be taken to eliminate the mortgage prior to retirement. A person already in retirement with a substantial mortgage and with most funds inside a 401(k) account does not have many good choices.
Consider, the case where a retired person has all of her wealth in a 401(k) plan. She took out a 30-year $450,000 mortgage 25 year before retirement and has five more years of mortgage payments before the mortgage is retired. The interest rate on the loan is 4.0%. Her mortgage payment, principal and interest, add up to $2,148. (This was obtained from the PMT function in Excel.) The annual payment on her mortgage is $25,780. The outstanding balance on her mortgage is $116,654. (This was obtained from the FV function in Excel.)
She could continue to live in her house and make her monthly mortgage payments.
She would have to withdraw funds from her 401(k) plan to cover her mortgage expense and other living expenses including her federal and state tax bills. The larger disbursement to cover the mortgage increases her tax bill because the entire distribution from the mortgage is taxed as ordinary income. She likely has Social Security benefits to cover some of her other living expenses. However, the higher income from the larger 401(k) distribution to cover the mortgage increases the likelihood a portion of the Social Security benefit is subject to federal income tax.
It makes sense for people to reduce spending and 401(k) disbursements during market downturns to prevent rapid use of 401(k) funds. The person with a mortgage must withdraw funds from her 401(k) plan to meet the mortgage obligation regardless of the performance of the market. The existence of the mortgage limits the ability of this person to reduce distributions in response to a market downturn.
The person could pay the entire outstanding mortgage balance of $116,654 in one year. This would put her in a high marginal tax rate and would subject 85 percent of her Social Security benefits to tax in the year the large distribution was made.
The person could sell her house, pay her entire mortgage and move. Most elderly want to age in place.
The viability of the downsizing option depends on the price the person could get on her current house, the amount of equity in her house and the cost of alternative housing, which depends on the price of the new house or the rent. Hopefully, the new house would be purchased with cash not a new mortgage.
A person with a large amount of liquid assets outside of her retirement account could more easily pay off her mortgage. The tax from the sale of assets outside a retirement account are substantially lower than taxes on funds distributed from conventional 401(k) plans because only the capital gain portion of the disbursement is taxed and under current law capital gains are taxed at a preferential rate.
The problems described here could have been avoided by use of a Roth retirement account rather than a conventional retirement account. A post on the potential advantages of Roth retirement accounts will be available shortly.