Tip 11a: Paying off the mortgage prior to retirement is more important than padding the 401(k) plan.
Older workers are allowed to make additional contributions to their 401(k) plan. Many financial advisors advocate full use of these make-up contributions even if this results in their clients keeping a mortgage in retirement.
Many of the articles below suggest it is okay to keep a mortgage in retirement.
Let me be clear about my view.
For the overwhelming majority of households, keeping a mortgage in retirement is a huge mistake. The problems associated with keeping a mortgage in retirement are especially pronounced for a household with most of its financial assets in a 401(k) account. The entire disbursement from a 401(k) account is taxed at ordinary income tax rates. A retired person with all assets in his 401(k) plan must make larger withdrawals to cover the additional expense of the mortgage and the additional tax on the additional withdrawal.
Analysis: Let’s consider two people both 15 years away from retirement. One takes out a 15-year mortgage and pays off the mortgage on the day he retires. The other takes out a 30-year mortgage, makes a smaller mortgage payment and invests more in a 401(k) plan. Possible results after 15 years might look as follows.
|The 401(k) Strategy Versus the Mortgage Payoff Strategy
– Possible Outcomes
|Person A||Person B|
|Original Mortgage Value||$540,000||$540,000|
|Term of Mortgage||30||15|
|Mortgage Balance at Retirement||$348,531.12||$0.00|
|Equity in House||$251,468.88||$600,000.00|
|401(k) Balance in Retirement||$800,000||$400,000|
Observations on the possible outcomes from the two strategies:
- If the person continues to live in his house after retirement he must take a disbursement from the 401(k) of around $31,000 to cover the cost of the mortgage. The person will also have to disburse additional funds to cover the cost of tax on the additional funds. My guess is that this person has a marginal tax rate of at least 0.30 for federal and state taxes. This would result in total disbursement of around $44,000 ($31,000/0.7). If my numbers are accurate the net worth advantage stemming from the 401(k) investment strategy is almost entirely wiped out after one year.
- Is this comparison realistic? Possible yes and possibly no. If returns at retirement are low (think 2009) I have probably overstated the value of the 401(k) maximization strategy. If market returns are robust the person may have a larger 401(k) balance and net worth. But if the person who adopts a 401(k) maximization strategy plans to stay in the house he has to either pay the mortgage for15 more years or pay the mortgage off. The person in my example is not going to be able to stay in the house and continue to pay down the mortgage for 15 years unless the person had phenomenal returns on her 401(k) plan assets. However, in order to get high returns a person needs to take risk and allocate assets towards stocks rather than fixed-income assets. This person is both old and retired and should be avoiding rather than embracing risk.
- A person with all financial assets in his 401(k) plan will find immediately paying off the mortgage expensive. This person will have to withdrawal $348 plus the tax on the $348. If done in one tax year the marginal tax rate for federal and state taxes combined could easily be 0.45. Perhaps the mortgage payments could be spread out over two or three years but even then early payment of a mortgage from 401(k) assets is expensive.
- Many retired people with high levels of 401(k) assets and a high mortgage are likely to end up selling their house and buying a smaller one with whatever cash left over when they payoff their mortgage. Certainly, Person A in this example would be wise to quickly consider downsizing.
Concluding thoughts: Financial advisors do a very good job pointing out the tax advantages of 401(k) contributions during working years. However, the retiree with a disproportionate amount of assets in his 401(k) plan has a very large potential tax obligation. The tax bill in retirement is larger for people who must continue to pay off their mortgage. Perversely, the tax obligations of older people who are reliant of 401(k) assets increases in years they have large expenditures because of a financial or health emergency.
It is not surprising that financial advisors and bankers would favor 401(k) investments over mortgage pay downs. 401(k) fees are basically a percent of assets under management. A higher level of 401(k) assets is associated with higher revenue and profit for fund managers. Mortgage interest received by investors and bank profits will fall if people pay cash for houses or payout their mortgage quickly. Financial advice is often more closely aligned towards the interests of the financial advisor than the client.