Today I spent the day playing in a spreadsheet - one of my favorite things to do. In this case a client was inquiring as to whether they should cash in some of their IRA to pay off their remaining $74,000 mortgage. I was running some numbers to see how it affected their tax situation.
Normally, I would think cashing in a large chunk of the IRA was a bad idea, and that was my initial reaction. But I decided to do some number crunching before I came to a final conclusion, and I'm glad I did.
First of all, their mortgage rate was at about 8% and refinancing was not an option. If they could have taken out a reverse mortgage to pay off the existing mortgage that would have been a preferred strategy too. For reasons I am not going to go into, for them anything that required an appraisal was ruled out so refinancing and reverse mortgages were not viable options.
So, since they are stuck with an 8% mortgage rate, the first question is, do I think, net of fees, they are going to earn at least an 8% return on their investment portfolio? That is far from a sure thing. As a matter of fact, I think it is quite unlikely.
Next, traditional thinking says if they take a large IRA distribution it will bump them into a higher tax bracket. This is true in their case. They will pay taxes at the 28% federal rate on most of the extra distribution verses 25%, which is the next lower marginal rate. However, now they will need to take less out of their IRA each and every year going forward. When I lower their future IRA distributions, based on their income level it will mean less of their Social Security income is taxable. As measured over the time horizon of their remaining retirement years, by taking a lump sum IRA withdrawal now, paying off the mortgage and reducing future IRA withdrawals, they will pay less in taxes, not more.
What was surprising to me is that even if their mortgage rate was lower, this would still be a viable strategy because of the long term tax savings.
Read more pros and cons in Pay Off Mortgage Early - Pros and Cons