Thursday, November 17, 2016

Borrowing Money in Retirement? Maybe.

Does it make sense to borrow money when retired?  Usually not.

When I started this blog, I had a lot of debt.   And was killing me as I had to service that debt, to the tune of at least $3000 a month if not more.   And over the years, I had accumulated other debts, including really stupid debts like credit card debts, which were nearly impossible to pay off.

And the funny thing was, in the mid-2000's I was debt-free for a few months.  We sold our house to a developer, paid off all out debts, and started out as fresh and clean as a newborn babe.   That lasted about six months, and then we decided we "needed" to have a fancy house and than another house and back onto the debt train we went.

It took another eight years, but we sold off much of our "stuff" including the vacation home and are once again debt-free.

And it is a pretty liberating feeling.   So long as I can scrape together about $850 a month, I can pay for all of the overhead on my home - the taxes, insurance, utilities, and so forth.   This is a big switch from $3000 a month.   I no longer have to worry about where my next paycheck is coming from or "losing the house" to foreclosure.

To be sure there are up sides and down sides to being debt-free.  My (former) investment advisor called me a fool for paying off my mortgage.  He wanted me to invest that $400,000 with him.   But of course, he gets paid based on how much he can get people to invest, so I am not sure his advice was sound.   Also, if I did that, where would I get the $3000 a month to pay the mortgage?

And as you near retirement (or are retired) and your taxes go down to the 15% level, the advantages of home mortgage interest deduction start to evaporate.  In fact, the whole home mortgage interest deduction thing is just a sop to the middle-class and upper-middle class, who live in above-average homes that cost a lot of money.  For those of us living on retirement income, well, the home mortgage deduction may not exceed our standard deduction.

And right there is the conundrum about debt in retirement.   If you need to take out $36,000 a year from your IRA to pay your mortgage, that will knock you into the 25% tax bracket.   Now, the home mortgage interest deduction "makes sense" as it lowers your taxable income by $36,000.   But you are not "coming out ahead" as you have to pay interest on that loan.   You can't deduct your way to wealth.

For my situation, it makes more "sense" to keep the home as a paid-for asset (and it is an asset) and live in the 15% tax bracket (less than about $75,000 for married joint filers) than to take out more of my savings and pay 25% tax on it.   Not only that, by leaving the savings in savings it can expand and grow.   If I use the savings to pay a mortgage, I miss the opportunity to make more money - but give the banker an opportunity to make money from me.  And yes, this is an example where opportunity cost makes sense for the consumer.   It doesn't make sense in leasing arguments or borrowing for consumer bling.

As part of a retirement portfolio, a "paid for" home is a pretty safe asset.   Debt paid off is 100% safe, whereas if you incur debt in retirement, you may not be able to pay it off if your assets decline in value.  And yes, you can "cash in" on a home over time.  My neighbors just sold their house for about $380,000 and bought a smaller house in a less-expensive location for about $180,000, cashing in a cool $200,000 in the process.

But that is my scenario, where I am trying to live off tax-deferred savings in retirement.   For others, the scenario may be more complex.

I have two friends who are retired government employees with nice pensions.   They have little in savings accumulated over the years, as they always had a steady paycheck.  As a Federal pension, they are not likely to see a disruption in their money train before they die.   At age 70, they have a home mortgage, car loans, boat loans, RV loans, and whatnot.  They rarely pay cash for anything as they have income but not capital.   In their situation, borrowing makes sense, although saving up to buy these things might make more sense - and cost a lot less in the process.

And their scenario is not without risk.  As I explained in my upsidedown-RV and upsidedown-Boat postings, it is all-too-easy to borrow a LOT of money (like over $100,000 or $200,000) for these rapidly depreciating assets and end up owing the bank $20,000 to $50,000 when you decide to sell the boat or RV later on.   If all you have is a pension, well, you are kind of screwed.  And this is not a far-fetched scenario, but one that happens every day and one that has happened to some of my pension friends.

If you are going to live the cash-flow lifestyle, you still have to be very, very careful.

But what about borrowing for the 401(k) generation?   Ahh... here is where it gets tricky and you have to "do the math".

Say for example, you need to buy a car as your old jalopy is broken down.   You want to spend $20,000 on a car.   But if you take that out of your 401(k) or IRA in a lump sum, it may knock you into the next tax bracket, and you will pay 25% taxes on that money.   You might try taking out half in December and half in January to spread it out over two years, and try to stay under the $75,000 income level.   But that could be tricky for some folks.

Another idea is to get a low-interest loan, either as low-interest car loan or a home equity line of credit.   You could then spread the payments over a number of years, avoid going into a higher bracket, and thus avoid paying that 10% delta in taxes (and we haven't considered State taxes in this deal).

In some limited circumstances, it may make sense to borrow rather than pay cash, if it means avoiding a nasty tax bill.

On the other hand, if you expect to need a replacement car in five years, a better approach might be to take a small amount of money from your 401(k)/IRA over five years and set it aside for the car purchase.   It is like saving up to buy the car.   If you do the math right, it would keep you out of the 25% tax bracket and thus end up costing less.

Overall, however, debt in retirement is not a good thing, I think.   The stock market may fluctuate.  The value of your investments may vary over time.  But debt is as hard and fast as a rock, and you can only chip away at it a little bit at a time.   It is all too easy to end up with an intractable debt and no means of paying it off.