Tag: downsizing

The House Downsizing Decision: Options for the 401(K) Rich Person with a Mortgage

A 401(k)-rich person entering retirement with a mortgage should probably downsize to a less expensive home.


Situation One:  A person with $1,000,000 in a traditional retirement plan has a house valued at $700,000 and an outstanding mortgage with a balance of $152,576.  The monthly mortgage payment is $2,387.   This mortgage payment and outstanding mortgage balance is consistent with the person taking out a $500,000 mortgage 24 years earlier.

The only other source of income for this person is her Social Security benefit of $20,000 per year.  Should this person downsize to a smaller house?

Analysis of Situation One:  This person is in a difficult situation.  This retiree is in danger of quickly depleting her retirement account or having insufficient funds for basic consumption, under standard guidelines governing the disbursement of retirement assets.  

Financial advisors often recommend retirees follow the 4.0 percent rule.  This rule sets the initial disbursement from the retirement plan at 4.0 percent of the plan’s assets and adjusts future assets for inflation.

Under the four percent rule, this retiree’s annual mortgage payment during the first year of her retirement is 71.6 percent of her total 401(k) disbursement.  Higher disbursements could lead to rapid depletion of the retirement account and higher taxes because disbursements from traditional retirement assets are fully taxed.

The most obvious solution to this person’s situation is to sell the home to pay off the mortgage.  The person might be able to pay off the mortgage and buy a home for $596,000.  (Assuming selling, buying, and moving costs are around 7.0 percent of the value of the home.). 

Other options involve a new traditional mortgage, or a reverse mortgage. Both options are unattractive and of limited practicality.

A refinancing of the $157,425 mortgage to a 30-year term would lead to a $728 monthly payment or annual mortgage payments of $8,741.  The mortgage is probably not available for someone without wage income.  Also, current interest rates are now higher than 4.0 percent.  

A reverse mortgage allows a person to tap equity and stay in their home. The largest amount a person could borrow on a reverse mortgage is 80 percent of equity. However, a 60 percent borrowing limit is more practical since the borrower is responsible for taxes and maintenance on the home.  Obtaining additional resources from a reverse mortgage might make sense for an older borrower nearing the end of her life.  A younger borrow using a reverse mortgage is highly likely to outlive both her 401(k) wealth and the additional wealth obtained from the reverse mortgage.

Concluding Remark:  The person in situation one prioritized savings inside a traditional retirement plan over the elimination of a mortgage during her working years. This person also chose to contribute to traditional retirement plans instead of Roth plans.   Go to my collection of essays Financial Decisions for a Secure and Happy Life for discussion on prioritizing debt reduction and the use of Roth retirement accounts.  

The only real option during retirement for the 401(K)-rich person with non-trivial debt is downsizing to a less expensive home.  More posts on the downsizing decision will follow.

Downsizing and the Social Security Claim Decision

I am making up and answering my own financial questions.  Please send your actual questions to me.

Question:  I am turning 62 in 2013 and it is definitely my time to retire.   I am single and would like to do something other than work.  I have modest means.  My main assets are my house, my 401(k) plan and a small amount of liquid assets.  The current value of my home is $450,000.   My 401(k) balance is $250,000.  I have a mutual fund with $30,000.  I have no loans on my car, which is eight years old and has 100,000 miles.

I will be entitled to a Social Security benefit of $1,000 as soon as I reach age 62.  I need to leave my job and have some fun but I am worried that I will outlive my savings.  What is your advice?

Caveat:   Your situation may be similar to my fictional questioner but there are always more details to be considered.   Please consider but do not over rely on this advice.

Analysis:  Many people are in this situation.  Their total assets are relatively modest and most of their assets are tied up in their home.  Some liquid assets are needed for emergencies.  A new car purchase may not be far off

Since you were born in 1951, your full retirement age is 66 years.  The decision to claim Social Security early will result in a reduction in your Social Security benefits of around 25% relative to the benefit that could be obtained by delaying a claim until age 66.

http://www.ssa.gov/oact/quickcalc/earlyretire.html

Your financial security would be greatly enhanced if you could delay claiming Social Security benefits.  In order to delay claiming Social Security you need to either take disbursements from your 401(k) plan or somehow tap your housing equity.

 

Your 401(k) plan is modest and taking immediate disbursements is not a wise financial strategy.  First, the 401(k) balance might grow more if disbursements are delayed.  Growth in 401(K) assets is of course determined by market outcomes.  Second, a delay in 401(k) disbursements will allow you to either receive 401(k) benefits later in life or take a larger disbursement each year.

While your marginal tax rate is low it is important to remember that 401(K) disbursements are taxed as ordinary income.

Let’s consider the possibility of tapping home equity to fund your retirement.  In particular, let’s consider five options – (1) selling your home and renting, (2) selling your home and buying a smaller home, (3) renting your home to a tenant and renting a smaller place for yourself, (4) finding a roommate, and (5) taking out a reverse mortgage.

Selling your home and renting:    The viability of this option depends on the rent you must pay in your new place.  Moreover, you become susceptible to rent increases, which could be significant over time.   Work by Jonathan Skinner cited in a previous post indicates that renters must save more to have an adequate retirement income than do homeowners.

http://econweb.rutgers.edu/killings/Econ_364/7_Skinner_lecturenotes.pdf

http://www.nber.org/papers/w12981

The capital gain up to $250,000 on owner-occupied homes is not taxed.

Selling your home and buying a replacement home:  The viability of this option depends on the cost of the replacement home.  The replacement home could be in a place with a lower cost of living.  There are lots of articles on the web listing affordable retirement locations.

http://www.aarp.org/home-garden/livable-communities/info-07-2011/affordable-cities.2.html

http://money.cnn.com/galleries/2011/real_estate/1109/gallery.retirement_home_deals/index.html

One risk of relocating is that you may be unhappy in your new location, especially if you move away from family and friends.  You may want to keep your home and rent until you are sure you are happy at your new location.  However, you may have to pay capital gain tax on your old home if you delay its sale and it becomes an investor-owned property.

Renting your home to a tenant and renting your own place to live:   The viability of this option depends on the amount of rental income you will get. This option would allow you to move to a new location and determine if you like it.  There is a risk that your home will be vacant some months.   There is also a risk that your tenant will trash your home.  (I heard of one family who rented their home and had their home destroyed by their tenant’s six dogs.  The insurance company refused to pay.)  You will need to hire a reliable property manager.  You will be subject to unexpected expenses.  Rental income is of course taxed but your marginal tax rate is low.

Under this option, you may have to pay capital gains taxes on the gain on your home.

A roommate:  The viability of this option depends on the amount of rental income obtained from the roommate.  You need a compatible or at least non- disruptive tenant.

Reverse mortgages:  Many financial advisors advocate that individuals in your situation stay in their home and take out a reverse mortgage.  Reverse mortgages entail risk.  A recent New York Times article documents problems with reverse mortgages uncovered by federal and state regulators.

http://www.nytimes.com/2012/10/15/business/reverse-mortgages-costing-some-seniors-their-homes.html?_r=1&

Increasingly, the reverse mortgage market is dominated by smaller mortgage brokers and firms that were formerly subprime lenders.  Fees tend to be high and are often unrevealed.  There have been several cases where a spouse that was not on the reverse mortgage loans was required to repay the entire loan in order to remain in her home.  The rate of default on reverse mortgages is at a record high, 9.4%.  Moreover, an increasing number of people obtaining a reverse mortgage are doing so at a younger age; thereby, adding to their financial risk.

Concluding thoughts:  In my view, you need to delay claiming your Social Security benefit and delay disbursing funds from your 401(k) plans.   This could be accomplished by tapping your home equity.  There are a variety of ways to tap your home equity.

Avoid taking out a reverse mortgage.

Also, your retirement could be made much more secure if you found a part-time job.