Living a debt-free life is important, especially as you approach retirement. But there are worse things than debt.
If you had extra money, what would you do with it: destroy some debt or beef up your savings? The answer can vary depending on your circumstances.
Here’s this week’s question:
I turned 65 last month and I’m still working full time and wanted to get your opinion on whether you think it’s best for someone my age to sock away extra cash or pay down my mortgage? I don’t have enough in my 401(k) to retire on, and I still have a mortgage balance of a little over 100K on my home. I plan on working for at least 3-5 years or more and would like your opinion on whether you think saving for more cash on hand is better or paying down/paying off the mortgage is the best move for me?
The short answer, Retha, is you’ll probably be better off putting as much as possible into your retirement account rather than paying down your mortgage. Let’s take a closer look.
Retirement plan vs. mortgage: the math
In a working paper called The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings (summarized at this page of the National Bureau of Economic Research website), several academics examined the mortgage vs. savings equation and came to this conclusion: “38 percent of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice.”
Why would nearly 40 percent of people be better off socking away retirement savings vs. paying down their mortgage? In a word, taxes. For most people, mortgage interest is tax-deductible, retirement plan contributions are deductible and their earnings are tax deferred.
This tax arbitrage makes retirement contributions a better choice, at least for some.
Example: Say you pay 4 percent on your mortgage, and you’re in the 25 percent tax bracket. Every deductible dollar you pay in mortgage interest reduces your taxable income by a dollar, which saves you 25 cents in taxes. The net effect: Your after-tax cost of borrowing isn’t 4 percent, it’s 3 percent, because Uncle Sam effectively pays a quarter of it.
At the same time, when you contribute $4,000 to a traditional retirement account, that’s $4,000 you’re not taxed on, which saves you $1,000 in taxes. You’ll have to pay taxes on that money and the interest it earns when it’s withdrawn, but theoretically you could be in a lower tax bracket when that occurs.
Those deriving the maximum benefit from this tax arbitrage will be those in the highest tax brackets, earning the most on their retirement savings for the longest periods of time.
One other note: If your employer is matching your retirement contributions, this is a no-brainer. You never turn down free money, so you always contribute enough to your company plan to get as much matching money as possible.
After maxing out retirement contributions
The most Retha can contribute to her 401(k) for 2016 is $24,000: $18,000 in regular contributions and, because she’s older than 50, $6,000 in catchup contributions. (See limits at this page of the IRS website.) After maxing out her 401(k), should she add extra money to her savings or use it to pay down her mortgage?
Here the math is simpler.
If Retha is in the 25 percent bracket and has a 4 percent mortgage, we’ve established that her after-tax interest cost is 3 percent. That means unless she can earn more than 3 percent after-tax on her savings, she’d be money ahead by paying down her mortgage.
Put another way, if she’s paying 3 percent on her mortgage and earning 1 percent at the bank, she’s getting 2 percent poorer every year.
But I still wouldn’t suggest paying down her mortgage. Instead, I’d suggest leaving the mortgage in place and trying to earn more than 3 percent after-tax, at least for part of her savings, by taking a little more risk.
For example, after accumulating a hefty emergency fund, she might look into peer-to-peer lending, or dividend-paying stocks. From real estate to mutual funds, there are ways to beat the bank without taking on excessive risk. Depending on her tolerance for risk, willingness to learn and the size of her cash cushion, she should look into some.
So far, it’s been all about the math. But earning more than you’re paying isn’t the only consideration.
While living debt-free is a great goal, accumulating a pile of cash is critical, especially for those approaching retirement. Retha says she doesn’t have enough in her 401(k) to retire on, and it’s not hard to imagine a scenario where she’s either unable or unwilling to continue working. Should that happen, cash will be king. If push comes to shove, she could rid herself of the mortgage debt by selling her house and downsizing. But once she quits working, she has no way to generate more savings. So that’s where the priority lies.
Bottom line? Job one for people in Retha’s position should be to put aside as much as possible in tax-advantaged retirement accounts. Priority two should be saving as much as possible outside of retirement accounts. Only after building a comfortable cushion should you use spare cash to pay down a mortgage.
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I founded Money Talks News in 1991. I’ve am a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.