is it ok to have a mortgage in retirement?

Is it ok to have a mortgage in retirement?

Is it OK to Have a Mortgage in Retirement?

 

Is it ok to have a mortgage in retirement? What do you need to know? Should you have a mortgage in retirement?

Well, obviously it is best never to have a mortgage! But that’s not terribly realistic now is it? However, since money not going out is the same as money coming in (that is, lack of a fixed expense every month is like having extra money), paying off most of your fixed costs including the mortgage is the usual recommendation.

So, is it ok to have a mortgage in retirement?

 

Should You Pay off your Mortgage in Retirement?

Let’s look at a case study so we can review the options if it is ok to have a mortgage in retirement.

Dottie and Danny are 64 and 68, respectively. He is retired and on social security, and she wants to retire now. Do they have enough money to reach their retirement goals and pay off their mortgage?

Well, great question! In order to answer it, we have to understand what their goals are.

They want to retire with $120,000 a year on a 2.5M nest egg, and are considering if they should pay off the mortgage. If there is something left over at the end, the kids can have it, but otherwise they are happy to spend down all of their assets during their retirement.

Dottie is in good health and she plans on living another thirty years. She is the bread winner between the two and has a larger IRA and social security benefits. Danny, on the other hand, is a bit older and not in great health. He thinks he might live to be about 80 or 85.

So, what do you think, do Dottie and Danny pay off the mortgage?

 

What about a Mortgage in Retirement?

These folks just got a 30-year mortgage out at 3.5%. The home is worth 500k and the amount on the mortgage is 400k. They are not sure how long they want to live in the home, and they are ok carrying debt into retirement.

What are the advantage and disadvantages to paying off the mortgage before retirement?

What are the Advantages to Paying off the Mortgage before Retirement? 

There are advantages to paying off the mortgage before retirement. Being debt free has a wonderful psychological impact. There is less stress knowing you have less fixed expenses in retirement.

Also, there are less interest payments over time, which means you lose less money.

There may be a tax benefit for a mortgage payment, but this is less likely given the large standard deductions we have in the Tax Cut and Jobs Era.

Finally, consider your asset allocation. If you have a large amount of bonds or cash, you likely are getting less income from those assets than you are paying in interest on the mortgage. This negative arbitrage of rates argues to pay off the mortgage and thus increase your overall cash flows.

What are the Disadvantages to Paying off the Mortgage before Retirement?

There are also disadvantages to mortgage payoff prior to retirement as well. Most of them revolve around cash flow and taxes. For instance, if you have a large amount in your pre-tax accounts, you are likely better off taking the money out slowly over time rather than spiking your taxes via a large withdrawal in order to pay off the mortgage.

You are also less at risk to sequence of returns risk if you have cash and a mortgage rather than less cash and no mortgage. This is counter to logic, but keeping flexibility during early retirement has many advantages.

If you are planning on selling the home soon, it may not make sense to pay off the mortgage.

Finally if you have a large amount of pension, social security, or annuity income, it may be fine keeping

 

How Long Should My Mortgage be in Retirement?

Prior to retirement, if you are going to have a mortgage anyway, you might as well get the longest mortgage possible.

Since retirement is largely about cash flows, having the smallest payments possible make a lot of sense.

Of course, balance this against the amount of interest you will pay over the life of the loan if you only have a few years of payments left.

 

Back to the Scenario

Since they are ok with debt, it may be best if they keep the mortgage rather than try to pay it off. This is especially true as they may move in the next 5-10 years.

Now, they have the greatest flexibility. If they don’t pay off the mortgage, they can have liquid reserves in case the economy goes bad (and it will at some point!).

Once they pass the worst of the sequence of returns risks, they can always just pay it off, or get a reverse mortgage. Most likely, however, they will move at some point; it doesn’t make a ton of sense to pay off the mortgage.

Plus, they can’t afford to pay off the mortgage! At least not without a large tax bill!

In order to demonstrate that, let’s see what they have for tax diversification.

 

Tax Diversification When Considering a Mortgage in Retirement

Let’s see where their money is located.

 

is it ok to have a mortgage in retirement?

Figure 1 (Tax Diversification Summary)

You can see above, they do have some money in the Roth as a tax-free asset. However, they have quite a bit of money in tax deferred, which may be a problem. Fortunately, most of the tax deferred money is Dotties’s, so she has a longer period of time before she needs to take RMDs.

You see they could pay off the mortgage with the money in their brokerage account, but this would leave them with minimal cash reserves. That doesn’t allow for much flexibility, as it would force large distributions from the pre-tax retirement accounts if they have a lumpy expense.

Usually at retirement, the plan is to have 2-3 years of assets in cash. Then, once a year, you can look forward to next year’s spending and decide what distribution you want to take from your IRA, and fit this into your best tax bracket.

But what tax bracket should they expect to be in during retirement?

 

Tax Planning and a Mortgage in Retirement

Doing a 20- to 30-year tax projection is important to know how best to manage your pre-tax retirement accounts.

 

tax implications of a mortgage in retirement

Figure 2 (Tax Bracket Planning and a Mortgage in Retirement)

You can see above tax bracket and partial Roth conversion planning. There is a lot of information packed in here, but this is often the heart of retirement planning for folks with large IRAs.

Note in dark green (which becomes light green later) is their projected income and the effect of RMDs without partial Roth conversions.

RMDs start at age 72, but note that there isn’t a bump in the taxable income at that time. This is because they actually need distributions to live on from her IRA between 70-72.

Over time, we can see that Danie dies when Dottie is about 83, and her tax brackets get smaller as she is now filling as a single. This is called the Widow Penalty and is important to consider. Without the partial Roth conversions, her RMDs eventually force her into the 35% tax bracket. Can we do better than that?

Yes! Let’s look at the blue which is their plan with partial Roth conversions. It looks like they have some room in their 12 tax bracket to do yearly partial Roth conversions. What a steal! She was a high-income earner, so she deferred taxes at the 39% tax bracket and now is paying 12 or 15% to take that money out. Also, in the future, this decreases the tax liability and keeps her out of the 35% tax bracket (the highest yellow line) when she is a Widow.

Doing these Roth conversions saves them a ton of money over time, but they need money in the brokerage account to pay the taxes!

If they pay off the mortgage, they cannot do Roth conversions and wind up owing a ton more in taxes!

In this case, it makes a lot of sense to keep the mortgage in retirement so they have the cash to meet other goals–such as Roth conversions!

Finally, note they save almost $2M by doing partial Roth conversions and using a sensible tax-efficient withdrawal strategy. This is over 30 years, but it is still a nice return on investment by doing a little fictional retirement planning.

 

Pre-Paying the Taxes?

 

should you have a mortgage in retirement?

Figure 3 (Pre-Paying the Taxes)

Just let’s have a quick peak at figure 3. This shows the amount owed to federal taxes every year during retirement. Note they could pay next to nothing for taxes during their Tax Planning Window, but if they do so, the “tail” during late RMDs become huge. By doing Roth conversions into the 12/15% tax bracket, they pay $450k less in taxes over their lifetime.

 

Summary- Is it Ok to have a Mortgage in Retirement?

So, there you have it. What do you think? Is it ok to have a Mortgage in Retirement?

In this case, it make a lot of sense to keep the mortgage even though they had the cash to pay it off. Instead, they use the cash for tax planning and save a lot in taxes over the decades.

Other considerations are a reverse mortgage, or to get a new 30-year fixed mortgage.

When deciding if it is ok to have a mortgage in retirement, there are many different considerations. If you can pay it off, do! But if you can’t pay it off, you may have pension and other guaranteed lifetime sources of income that easily offset the liability.

 

 

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8 Comments

  1. Thanks! As you know, it is not so much a wrinkle as it is the whole point of retirement planning!

  2. Top of the 24% for some, top of 12% for others, and up to 35% for few with massive RMD problems. It all depends on your other sources of income and future expected tax rates for your pre-tax accounts and RMDs. I like to come up with a conversion “number” which is the goal tax rate to convert up to…

    I’m not sure that interest rate attractiveness is the right way to look at when to sign up for a QLAC. After all, who has been right about interest rates over the last 10 years? It might have more to do with where you are on the spectrum Safety-First vs. Risky Assets, and how much you think your cognitive abilities will still be there in a few years. Think about it this way: the deferral period has to offer you better returns than owning individual bonds due to risk pooling and mortality credits. So if you offset the QLAC purchase by removing the same amount of bonds from your portfolio, you must be better off regardless of the interest rates. It is folks who keep the same asset allocation after buying a QLAC that might not do quite as well from a risk-adjusted return perspective.

  3. That’s a tough combo to pull off! Especially because the Tax Cut and Jobs Act is expected to sunset just when you are no longer eligible for ACA credits and likely will want to Roth convert… then at more expensive tax brackets!

  4. Thank you for this thoughtful post!

    Too many times when one reads on this topic the immediate premature conclusion is it “always better to pay off the mortgage so one you can live for free”. Last time I checked insurance, property taxes, and HOA fees are not going anywhere and in fact are going up each year so nobody “lives for free” with or without a mortgage. We prefer the flexibility of having the financial reserves than to have our money tied up in our home, especially with our mortgage interest rate now at 2.5%. We may also considering moving in the next 5-7 years.

    Nothing wrong with paying off a mortgage if one has the ability to do it, but there are many factors to consider as you point out.

    Thanks for what you do!

  5. And then you have my scenario. I live in the San Diego area. I had a 15 year loan at 3.5% that I made additional monthly payments on and was able to pay off my mortgage 5 years earlier. That was 5 years ago when I was fully employed and it was easily affordable for me. Now my house is worth $1.6M and I have been working half time (and enjoying my practice much more!). My retirement account has $3.9M in it. I also have a Navy pension after 38 years of active and reserve duty worth $3500/month. When I hit 70 in 15 months I’ll take social security and with my wife’s social security that will be around $5900/month. I have a well and solar electric panels that save me an annual expense of well over $7000/year in after tax money. Now my time is filled with tending my vineyard and making wine, travel, cruising the beach in my two classic cars, touring on my motorcycles and playing with my grandkids. What did I do wrong?

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