Consider this Likely Future Tax Benefit of Early Mortgage Payoff
Mr. ToughMoneyLove has participated in many online debates among readers of personal finance blogs and retirement planning message boards. A frequent topic of debate is the wisdom of using available free cash flow to invest or instead to make an early payoff of an existing mortgage loan. I am not a fan of debt generally but I do respect logical arguments supporting overall wealth building in combination with reasonable debt used to purchase an appreciating asset, such as real estate.
The Usual Tax Benefit Argument in Favor of Mortgage Debt? It’s Flawed
The investment return argument has some validity but most people over-simplify it. By this I mean that their analysis of the tax benefit fails to consider that only that portion of the annual mortgage interest paid that exceeds the taxpayer’s standard deduction (or married standard deduction) is really providing a benefit. This makes it a much smaller benefit than most people appreciate. For example, a married couple filing a joint tax return in 2008 is entitled to a $10,900 standard deduction. If that couple pays $10,000 in mortgage interest and has another $2500 in deductions, the couple can elect to deduct $12,500 instead of taking the standard deduction. However, they are receiving an actual tax benefit on only the difference between the total of that couple’s deductions ($12,500) and their standard deduction ($10,900), or $1600. If that married couple has an effective tax rate of 25% (not the marginal rate which is the wrong number to use), the mortgage interest is providing a real tax benefit of only $400. The couple is paying $10,000 in interest to save $400 in taxes. That is the hard truth. Run the numbers yourself.
Social Security “Means Testing” is Coming
What I don’t see much of in the “invest vs. mortgage payoff” debate is a serious consideration of future tax benefits from paying off the mortgage, particularly as to homeowners who are within five to ten years of retirement. Let’s talk about this logically.
Most economists and financial analysts expect personal income tax rates to increase substantially in the next five to ten years. Why? To pay Social Security and Medicare benefits to retiring baby boomers who will be flooding the system. There is no debating that these government entitlement programs are grossly underfunded and that radical steps will be needed to prevent a complete default on payment of promised benefits. If you don’t believe me, here is one Q & A taken directly from the Social Security Administration web site:
Q: How big is the future problem?
A.: Social Security is not sustainable at currently scheduled levels over the long term with current tax rates without large infusions of additional revenue. There will be a growing shortfall once the trust fund reserves are exhausted in 2041. Social Security’s Chief Actuary projects that in present-value dollars the financial shortfall (or unfunded obligation) for the 75-year period is $4.3 trillion. This unfunded obligation is equal to 1.6 percent of the taxable earnings or 0.6 percent of the nation’s gross domestic product (GDP) over the next 75 years.
(Did you see the $4.3 trillion “unfunded obligation” number in there?)
Similarly, many knowledgeable observers expect part of the Social Security and Medicare funding shortfall to be reduced by adding “means testing” to determine the benefit levels paid to retirees. If implemented (which I predict will happen), “means testing” will cause the magnitude of a taxpayer’s Social Security retirement benefit, and/or the taxation of that benefit, to be tied to that taxpayer’s other income. In other words, if a retiree has done a good job of saving and investing, that retiree will own retirement assets capable of providing a substantial retirement income to supplement Social Security. With “means testing”, our government will punish that retiree for wisely saving and investing. How? By reducing that retiree’s Social Security retirement benefit and/or taxing those benefits into oblivion. (After all, no good deed goes unpunished, does it?) More hard truth.
Here Comes the Future Tax Benefit of a Paid-Off Mortgage
Now we have a situation where a retiree with moderate retirement assets wants to keep as much of the retirement income benefit of those assets without being battered by increased income taxes or decreased Social Security benefits, triggered by “means testing.” Obviously, one way to do this is to provide income to that retiree that is not taxed. A paid off home provides this, in the form of imputed income. I will explain. If a retiree has a monthly mortgage obligation of $1500 in principal and interest, he or she will need a monthly income to fulfill that mortgage obligation. Generally, this means periodically drawing down on retirement funds. Unless those funds are all coming from a Roth IRA or Roth 401(k) account (unlikely), at least some of those withdrawals are going to trigger taxable sales or distributions. These income generating taxable events go right into the “means testing” formula.
On the other hand, if the retiree is living in a home with a paid-off mortgage, the retiree is not having to withdraw retirement assets to make mortgage payments. Yet the retiree is still receiving the same benefit of living in the home. The retiree is receiving a shelter benefit equal to $1500 per month. This is a tax free benefit and one that will not be considered in any “means testing.” Therefore, having a paid-off mortgage may very well maximize the Social Security retirement benefit and minimize taxation of those benefits, because the retiree will not need taxable income to pay most of the retiree’s shelter expenses.
Now we don’t know exactly how large this tax benefit will be because we cannot predict precisely how means testing will be implemented. Nevertheless, I contend that it will be greater than any tax benefit from the mortgage interest deduction and, based on probable future market investment returns, the taxpayer will come out ahead in total dollars.
It Works for Car Loans and Non-Retirees Too
By now I hope you have figured out that this same analysis can be applied to the debate over financing vs. owning a paid-off motor vehicle. Moreover, those of you who are years from retirement should also consider whether having a paid-off mortgage will provide you a tax benefit by allowing you to do things with your investment income other than paying your shelter expenses.
So next time the “mortgage vs. no mortgage” debate comes up in conversation or in your own mind, don’t overlook the personal finance and retirement planning effects of future tax rates and Social Security means testing.