Tip #9: People with mortgage debt in retirement must often take large taxable distributions from their 401(k) plan regardless of the level of the stock market. The elimination of all debt prior to retirement substantially reduces the likelihood a person will outlive their retirement savings.
General Discussion: Many financial advisors believe it is appropriate for their clients to keep some debt in retirement. They will advise their clients to take out a 30-year loan instead of a 15-year loan to increase contributions to a 401(k) plan and to take full advantage of the deductibility of mortgage interest. They also argue that people nearing retirement should make additional catch-up contributions to their 401(k) plan instead of increasing payments on their mortgage.
The decision to keep debt in retirement is a recipe for financial disaster, especially if the household is reliant on fully taxed distributions from a 401(k) plan and partially taxed Social Security benefits.
Issue One: The person with debt will more rapidly deplete their 401(k) plan and will pay higher taxes in retirement.
Discussion: A person taking out a 30-year $500,000 mortgage, 15 years prior to retirement has annual mortgage expenses of $26,609. The person that used a 15-year mortgage enters retirement debt free. See the example presented in Financial Tip #4 Guidelines for the choice between a 15-year and 30-year mortgage.
The person with the mortgage debt must either reduce non-mortgage expenditures or distribute additional funds from their retirement account to maintain the same consumption as the person that paid off her entire mortgage prior to retirement.
Large tax-deductible mortgages reduce payment of federal and state income taxes in working years but increase payment of federal state and income taxes in retirement.
- Retirees without business expenses generally have lower itemized deductions than people in their prime earnings years, hence, the advantages from itemizing in retirement are often small.
- An increase in the distribution of 401(k) funds to cover the mortgage is fully taxed as ordinary income.
- An increase in 401(k) distributions increases the amount of Social Security subject to income tax as discussed on this page offered by the Social Security Administration.
Issue Two: The person without debt is better able to maintain current consumption levels and preserve wealth during market downturns.
Discussion: Typically, a person attempts to maintain a certain level of consumption perhaps 60 percent of pre-retirement income throughout retirement. A person with a mortgage or a monthly rental payment is less able to reduce expenditures when the value of stocks in their 401(k) falls because the mortgage payment or the rent are not optional.
Any reduction in disbursements from 401(K) plans, which are reduced in value due to a collapse in stock prices, would have to occur from a reduction in non-housing consumption.
The largest financial exposures occur when the market falls by a substantial amount in the early years of retirement when the entire savings from working years is exposed to the market. The market downturn in stocks in 2008 was somewhat offset by an increase in bond values. This time around both stocks and traditional bonds appear to be in a bubble. People may want to consider Series I or inflation bonds as discussed in financial tip #7.
Still, the best way to prepare for a market downturn is to eliminate all debt prior to retirement.
Concluding Remarks: During working years, many households take on a large amount of mortgage debt to reduce current year tax obligations. Failure to eliminate all mortgage debt prior to retirement often leads to rapid depletion of 401(k) assets, higher income tax burdens in retirement and increased exposure to financial volatility.