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Let's say you're going to retire next month. You need $5,000 a month to live your current lifestyle. You owe $100,000 on your mortgage with 12 years left until it's paid off. The interest rate is 3.75%. Your mortgage is $1,400 a month and included in the $5,000 a month budget you've created. You have $70,000 in cash in the bank. You have $690,000 in an IRA. Social Security will bring in $4,800 net after tax and healthcare expenses. You're a healthy, happy 67 years old.
My question is: do you pay off your mortgage with your cash and IRA or keep paying your mortgage and leave your cash and IRA alone?
Before you answer that let me tell you the correct answer up front so as to save you time. The ironclad, non-negotiable, black-and-white answer is ... It depends.
Mathset For a Mortgage
Some of you nerds who actually read my blog will sharpen your pencils and get out your slide rule. What you will discover is that historically, the markets go up. So leaving your IRA alone makes sense.
You'll also discover that historically, the United States government pays Social Security faithfully month after month.
Historically, 3.75% for 12 years is a fair price of funds. This is especially so considering the historical returns on a blended portfolio are typically north of 3.75%. So the mortgage to IRA arbitrage seems prudent. Furthermore, if we take out $30,000 from our IRA, we'll pay a marginal rate of about 22% in this hypothetical scenario. That means we'll need to distribute almost $37,000 and withhold for taxes to net $30,000. That's expensive money, isn't it?
Historically, if you take a large distribution from your 401k and those years are followed by a bear market cycle, you are susceptible to the sequence of returns risk. If you don't know what that is, then you need to read my blogs, because it's pretty much all I ever talk about, ad nauseum.
From a tax standpoint, we are in a favorable tax code to make a larger distribution from our IRA. However, in the future will mortgage interest be a key write-off for retirees who have little to no other tax avoidance strategies?
Mathset Against a Mortgage
So am I saying you should not pay off your mortgage with your cash and IRA? Not at all. I'm just getting started with my mathematical machinations.
Historically, the market goes through bull and bear market cycles. We have gone through a ten year bull market, albeit with interruptions. But seen from 20,000 feet the charts from 2009 to 2021 look like we are at the tip top of Mount Everest. The argument could be made that a measly IRA distribution would be a great way to diversify out of the stock market and into the roof over your head.
Historically, we are making record low interest rates on cash. While a 3.75% interest on your mortgage is fair, wouldn't cash at .01% be better deployed at retiring debt at 3.75%? To put it another way, you'd be delighted to invest $70,000 at 3.75% and in a sense that's what your doing by retiring 70k of debt at that rate.
Historically, this is one of the best tax scenarios retirees have ever seen. Social Security has favorable tax status compared to earned income. It would make sense to pay taxes today on your sizable distribution before the many tics in Congress figure out how to suck the lifeblood out of your cash flow. (Poly means many and tics are bloodsucking animals. Hence, Politicians.)
Once the mortgage is paid off, you have retired the Principal and Interest (PI) but you still have Taxes and Insurance (TI). But now, your monthly budget is reduced so much that your cash flow can fill your savings account back up quickly. Once you get to a comfortable cash reserve you're only exposed to property taxes and insurance going up. But in our hypothetical scenario, you need very little more than what is deposited every month by good old Uncle Sam in the form of Social Security.
Mindset over Mathset
Okay, I'll stop arguing for or against in this made-up scenario. The bottom line is you have to pick your poison. Whatever you do, there's an upside and a downside. Furthermore, most of the arguments I'm making here are based on history. Unfortunately, we don't live in the past. We live in the now and make educated guesses about the future.
So pick your poison. Pay taxes now or pay taxes later. Sleep better at night because you don't have a mortgage or sleep poorly because you have no savings in the bank. Sleep better tonight because you have $70,000 in the bank or toss and turn because you hate owing the bank a dime. Take a large distribution before a market crash and you'll brag about it to all of your friends. Take a large distribution before a market boom and you've missed the opportunity of a lifetime.
Your situation will be different, but one thing is the same. Mindset trumps math set. We can make math say anything. In this situation, a blended, comprised approach would be prudent. And only after we discuss all the poisons we have to pick. My job is to have the heart of a teacher. Let's learn together.