Forget the Deductions:
Why you should pay off your mortgage before you retire

More Americans are quitting the work force without retiring their mortgage. Big Mistake? It could prove more taxing than they ever imagined.

According to the most recent Federal Reserve Survey; of Consumer Finances, 32% of households headed by someone age 65 to 74 were carrying home-mortgage debt as of 2001, up from 26% three years earlier.

“It’s like a financial plague”, says Michael Maloon, a financial planner in San Ramon, CA. “We’re getting away from those Depression-era values”.

True, mortgage rates are low and mortgage interest is one of the last great tax deductions. Nonetheless, carrying mortgage debt into retirement can wreak financial havoc.

Debtor’s prison. To understand why, imagine two couples who just retired at age 65.

The first couple lives comfortably on $16,000 a year from Social Security and $24,000 from their individual retirement accounts. They don’t owe any tax on the Social Security because a combination of their income and half of their government benefit doesn’t breach $32,000- the threshold at which a couple filing jointly has to start paying taxes on their Social Security.

Our first couple would, however, be taxed on their IRA withdrawals. Figure in their two personal exemptions, the standard deduction and the additional standard deduction for folks age 65 and older and they would owe Uncle Sam just over $600, leaving them with $39,400 in after-tax income.

Our second couple could also live comfortably on that sort of after-tax income, except for one small problem: They still have a mortgage. At age 50, they had taken out a$200,000 30year fixed =rate loan at 6%, putting them on the hook for $1,200. every month until age 80. In other words, if our second couple wants to match the first couple’s stand of living, they would need enough after-tax income to cover both $39,400 in living expenses and $14,400 in annual mortgage payments.

As our second couple strives to generate that cash, they can take advantage of the mortgage-tax deduction. Both that doesn’t prove to be much of a bonanza. The reason: With each successive mortgage payment, a bigger chunk of their monthly mortgage goes toward principal and less to interest.

Indeed, with our second couple now in the 16^th year of their mortgage, just $8,400 of their $14,400 annual payments goes toward interest. Tack on $5,000 for other deductions of $13,400 modestly above the $11,600 standard deduction taken by our first couple.

Despite that tax break, our second couple discovers that retirement is pretty darn taxing. How come? To pay the mortgage while matching the first couples stand of living, not only does our second couple have to make hefty taxable withdraws from their IRA, but also those withdrawals drive up their total income, thus triggering taxes on the Social Security.

Results: Our second couple would need total pretax income of more than $58,000, calculates Glenn Frank, a financial planner in Waltham, Mass. That means drawing more than $42,000 from their IRA- 75% more than our first couple- and paying more than $4,300 in federal taxes.

In effect, our second couple’s $14,400 annual mortgage is costing them more than $18,000.” There’s a surprising sting there”, Mr. Frank says.

For unsuspecting retirees, the financial hole can be even bigger. Because those senior don’t realize their Social Security has become taxable, they may fail to make the necessary estimated tax payment. That could result in tax penalties, which necessities further IRA withdraws, which trigger further taxes.

Harvey Gillis, a semi retired executive in Snohomish, Wash, has been trying to get politician to fix this nasty tax trap. “This thing is worse than the alternative minimum tax”, he contends. “Its middle- class mire”.

Buying freedom.  Faced with this mess, our second couple might be tempted to yank a big chunk out of their IRA and rid themselves of their mortgagee. But that also isn’t cheap, because they still owe more than $142,000 on their loan.

In fact, if our first couple wanted to pay off their mortgage while also covering their $39,400 in after-tax living expenses, Mr. Frank calculates they would need to withdraw $217,000 from their IRA and pay almost $52,000 in federal taxes. (This assumes, once again, that our second couple receives $16.000 from Social Security).

Carrying mortgage debt into retirement doesn’t create just tax hassles. You also lose financial flexibility because you have the big fixed monthly cost. That can make for tough choice in down markets, as you try to figure out which investments to sell in order to make the monthly mortgage payment.

In addition, your mortgage debt will limit your ability to tap into your home’s value through a reverse mortgage. As I see it, a reverse mortgage is the financial backstop for cash-strapped retirees. But if you already have a conventional mortgage, a reverse mortgage may not garner you much cash.

What to do? The solutions obvious: Next time you refinance or buy a new home, tailor the length of your mortgage to your expected retirement date.  Alternatively, make extra principal payments, with a view to paying off your mortgage by retirement.

As Mr. Maloon, the financial planner, argues, “Every homeowner should have the goal of using their last paycheck to make their last mortgage payment.