Paying off the mortgage is a noble goal and is a great idea for most Americans. Having a ‘mortgage burning’ or ‘debt free scream’ is a freeing event that brings peace of mind knowing that you own the roof over your head. However, while paying off the mortgage is a noble goal, retirees should think twice before pulling a lump sum out of an IRA to finish off the mortgage. In this article, we’ll walk through the numbers to show why it is almost always better to leave the IRA alone and pay down the mortgage over time.
The biggest problem with using IRA money to pay off the mortgage is that it comes at a cost – a tax cost. Money in an IRA has not yet been taxed and will remain untaxed until you pull it out. Annual draws for living expenses usually keep retirees in lower brackets, but a lump sum draw for mortgage payoff can spike income into much higher brackets. For example, a retired couple living on a $100,000 annual draw from an IRA is usually in the 15% federal tax bracket after exemptions and deductions. If this couple took out $200,000 to pay off their mortgage it would spike their taxable income, pushing them into the 33% tax bracket. Add state taxes, especially in a high tax state like California and the tax cost of the lump sum distribution could be 40%, resulting in a tax cost of $80,000. An $80,000 tax hit to be done with the mortgage early is rarely worth it.
The second problem with using IRA money to pay off the mortgage is that it is hard to get the money back out of the house. This problem is a bit more subtle than the tax issue, but it is also important. For many retirees, the IRA must last a lifetime. Paying off the mortgage early can dangerously deplete the IRA so that it runs out in later years. If this occurs you may be forced to sell the house or do a reverse mortgage to get cash back out of the house. As comforting as it is to have a paid off house, it should also be comforting to have easy access to cash if you need it.
Some will say that they want to pay off the house to avoid the risk of the stock market and I understand that. However, there are many investments, bonds for example, that pay a reasonable return without the risks of the stock market. Moreover, keeping the cash in an IRA will avoid the 40% ‘decline’ from a tax hit, and allow you to still have ready access to the money if you need it for emergencies.
Of course, everyone’s situation is different. Small payoff amounts or high-interest mortgages may tip the scales. Nevertheless, as tempting as it may be to take a distribution and be done with debt for good, it is almost never a good idea. If you still want to pay off the mortgage consider a longer term plan like 10 or maybe 5 years to spread the cost and stay in lower tax brackets. Also, make sure that you have a solid retirement plan with sufficient assets before you lock up the money in your house. If you need some help, we would be happy to help you with the analysis.