In general, the higher your tax bracket, the greater the potential benefit of a mortgage. Once retired, your tax bracket is likely to be lower. Before deciding to pay off your mortgage early, consider the tax impact of your mortgage both before and after retirement.
Taxes and Your Mortgage Before Retirement
If are a working age adult in a higher tax bracket, and you itemize tax deductions, you can take advantage of a form of tax arbitrage by choosing not to make extra payments on your mortgage, and instead taking full advantage of contributions to tax-deductible retirement accounts.
This works if you are able to deduct the interest you pay on your mortgage, and deduct the contributions to tax-deductible retirement accounts (like 401k plans or deductible IRA accounts). This strategy is of the most benefit to those in the highest tax brackets.
Don’t make this decision solely based on taxes. You’ll also want to consider the level of investment risk that you are comfortable with compared to the risk-free return of paying off your mortgage. In addition, you want to create a balance between taxable and tax-deferred investments; if you don't, tax-deferred investments can end up hurting you.
Taxes and Your Mortgage After Retirement – A Good Time To Pay Off Your Mortgage
Once retired your tax situation may change. It is likely you will be in a lower marginal tax rate, in which case the mortgage interest rate deduction will not provide as great a benefit to you.
In addition, if you have investments in taxable accounts, the interest from these investments will increase your modified adjusted gross income, and may affect the amount of taxes you pay on your social security retirement benefits.
Depending on your personal tax situation, once you are retired, it may make sense to reposition taxable investments to pay off your mortgage, which may reduce your taxable income to the point where you will pay less tax on your social security benefits.
If you are thinking of withdrawing investments from tax-deferred retirement accounts to pay off your mortgage, use caution. Withdrawals from tax-deferred accounts are included in your taxable income in the year you take the withdrawal. This means if you take a large chunk of money out of an IRA or 401k, the extra income could bump you into a higher tax bracket. You can potentially avoid this by breaking up large withdrawals into smaller increments to be withrawn over several calendar years.
