Friday, December 27, 2013

No Mortgage = huge raise in pay

Owning your home free and clear is like getting a huge raise in pay - the money you save is more than just the annual interest rate.

My investment adviser at Fidelity is a nice guy and pretty smart and all.   But he thinks I'm an idiot for paying off my mortgage, instead of keeping the house in hock and of course investing the $400,000 with him.   You can't blame him for that - he gets paid based on how many assets he handles, and my paid-for house doesn't count toward that goal.

Of course, he's in his 30's, and has a wife and two kids, a hefty mortgage, car payments, and the whole bit.  The idea of actually owning anything at this stage in his life is alien to him.  And it was to me, when I was 30.

His argument is that the interest on the mortgage is only about 5% or so, these days, and you can make more than that in the marketplace.   But it is a flawed argument.

I pointed out to him that not having a mortgage payment is like getting a huge raise in pay.  And for people who are retired and living on their savings - or for self-employed people who would rather work less, it is an argument that makes sense.

What do I mean by this?   Well., a $400,000 mortgage, at 5% interest, comes to about $2147.29 per month, just for principle and interest.  As I noted in another posting, the other costs of owning this home, including utilities, taxes, and insurance, come to another $1000 a month.  (And it goes without saying that getting a 5% interest mortgage these days is getting harder and harder to do - and let's not even talk about the fees involved).

In order to earn the $25,767.48 every year needed to pay this mortgage, I would have to earn far more than that, in order to pay the Federal Income taxes, Social Security and Medicare Taxes (the self-employment tax, in my case) as well as State Income Taxes.   The self-employment tax alone is 18%.  Throw in 25% for the feds, as well as another 6% for the State of Georgia, and I need to make 49% more money just to net the amount for the mortgage payment, or $38,383.54.

There are two things to note here.  First, this extra income needed might actually push me into a higher income bracket - from the 15% rate to the 25% rate, so we end up paying more in taxes.   If you are retired and taking money out of your 401(k) or IRA to pay a mortgage, you may end up paying out at rate higher than you paid in, or at the very least, not much lower than you paid while earning.

The whole point of the 401(k) and IRA system was to take a deduction while you were in a high bracket (25% or more) and than pay out at a lower bracket (15%) and thus save on taxes.   If you retire with a mortgage, and your income needs are high, you negate this advantage of the IRA and 401(k).   If you have no house payment, when retired, you can live on very little money, and thus end up in a lower tax bracket - by taking out less from your IRA or 401(k) plan.

But speaking of deductions, my calculations above did not factor in the home mortgage interest deduction.  And this brings up an interesting point from a number of angles.   When you buy a home, the first few years of payments are nearly all interest - so your home mortgage deduction is high.   As the mortgage winds down, you end up paying mostly principle and little interest - to the point that in the last few years of a mortgage, the deduction may not be higher than your standard deduction.  So, if you retire with five to ten years left on your mortgage, you may end up not getting the advantage of the home mortgage interest deduction.

But let's look at it from the flip side.  Suppose you just bought a retirement home, and encumbered it with a 30-year mortgage, rather than just pay cash to buy the place outright.  Your financial adviser (like mine) says this is a swell idea, as you can "invest" this money in his mutual funds, which is swell for him, as he gets a commission.   And if the market is going gangbusters, like it is today, that is swell for you, too, provided the market keeps going like gangbusters.   If it doesn't, well, you lose it all - and still have a mortgage to pay.

And that is why most financial advisers (the good ones, anyway) suggest you put your money into safe harbors as you get older.   A 70-year-old has no business playing the market that late in life.

But getting back to the Interest deduction, the first year of that mortgage, out of the $2,147.29 payment, $1,666.67 is pure interest, and less than $500 goes towards principle.   Granted, this means you can deduct that amount from your income, and avoid paying the extra taxes.   However, very few people stay in their homes for 30 years, and thus taste that sweet spot at the end of the mortgage, where most of every payment goes to pay off principal.

(Note that when you pay 5% in interest, it is not on the amount of your payment, but on the overall balance, so the beginning of any loan is almost all interest).

The average home is bought and sold about every five years in America.   If you buy a $400,000 home today, and mortgage it at 5%, you will pay nearly $100,000 in interest payments, over five years, before you sell the home for not a lot more than what you paid for it, plus the closing costs.   Yea, yea, yea, that amount is deductible and all, but again, you can't deduct your way to wealth.   Regardless of whether it cuts your tax bill, you still have to pay the $100,000.   And for a retiree, the tax bill being cut is the one increased in the first place by the need to withdraw that $100,000 from the IRA.  It is a null-sum game.

Going into retirement with high income needs is never a good idea - not only will you drain your retirement funds more quickly, but you will pay the highest tax levels doing so.

For example, take Fred.  He's old enough to retire and collect Social Security, but he still works and makes good money.   Good enough money to put him in the 28% bracket.   He hasn't touched his 401(k) or IRA money - regularly - although he can withdraw from both accounts, now, without tax penalty.

But then trouble strikes - as it is wont to do, when you are retired.  The house needs repairs, and he has to take out $50,000 from his IRA to pay for it.   The problem is, in order to pay the taxes on that untaxed income, he has to take out at least $75,000 to cover Federal and State taxes.   It may even boost him into the 33% marginal bracket!

Fred notes that using his IRA money this way was wasteful.   He wishes he put the money into a Roth IRA instead (where he could now take out the money, tax-free).   Paying taxes at 28% or 33% is certainly wasteful - and higher than the 15% Capital Gains taxes he would have paid if this were after-tax money invested.

Of course, back when he was 30, those tax deductions were awfully sweet - and there is no way that age-30-Fred would have started a Roth IRA back then.   So the point is moot.  Age-62-Fred is stuck with the decisions that age-30-Fred made.  And they hate each other - that's typical.

So what's the solution?   Well, in retirement, it makes sense to keep your income needs low.    If you need a lot of money to maintain your "lifestyle" in retirement, then you end up having to pay a lot of taxes to do so.

One approach, which in the past was typical of most retiree's strategy - was to downsize.   Once the kids are grown and gone, there is no need to keep a five-bedroom house in a high-tax district.   Sell the house and use the equity to buy a retirement home, free and clear.   And Florida and Arizona and other retirement States are full of such homes, often selling for under $200,000 - often even far, far less.

Without that monthly "nut" to crack, one doesn't need huge amounts of money to survive.   So the IRA and 401(k) last longer, and you can take out money at a lower tax rate - benefiting from the design of these plans.

Speaking of withdrawals, Fred's situation illustrates why it is a good idea to take money out of your 401(k) or IRA after retirement, over time, and put it into an after-tax account.   If you are in the 15% bracket ($36,250 solo taxable income or less) but use less than the maximum amount for your bracket, then it makes sense to take out the difference, at the end of the year, and put it in an after-tax account.   That way, in a subsequent year, when you need a lump sum for a home repair to to buy a car, you have that money, already taxed, and don't have to worry about being pushed into a higher bracket.

You have only so many years left to live, so it makes sense to take out the maximum amount, in your bracket, and pay the lower tax rate, than to take out lump sums later on, and pay higher tax rates.

The goal of retirement should be to live on less.  Every dollar you don't have to spend is a dollar un-taxed.  And not having to pay a monthly mortgage leaves your life open to other possibilities.

Not having a $2000 a month mortgage payment is like getting a $40,000 a year raise in pay!