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

Most of us have heard or read the usual arguments.  Probably the number one argument against an early mortgage payoff is that the likely returns from investing the free cash will exceed the long term mortgage interest expense.  This position is further enhanced by taking into account the deductibility of mortgage interest on the home owner’s tax return.  Thus, the “keep the mortgage” contingent believes that they can earn 8%-12% annually before taxes on the invested cash.  (This assumption is itself statistically risky and unrealistic, something I think I will write about later.)  They compare this anticipated investment return to a typical 6% mortgage interest rate, which they discount downward based on deduction of the interest at a hypothetical marginal income tax rate.

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. 

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11 Responses to “Consider this Likely Future Tax Benefit of Early Mortgage Payoff”
  1. T A P says:

    Good presentation,- I heartily agree. Hope your siblings read and understand.

  2. Matt says:

    Nice counter argument here. I think many financial planning strategies will be retested during the golden years of the baby boomers.

    I think the most successful wealth advisers and financial planners will make tax advantaged savings/retirement plans a vital part of their strategies.

    I’d be interested in more articles along these lines!!!

  3. Matt – Thanks for the comment. Financial planners definitely will have some catching up to do plus we will need more fee-only planners for the baby boomers to work with.

  4. Oh and you will definitely be seeing more posts like this.

  5. MasterPo says:

    I agree with your assessment of paying off the mortgage and with all the new taxes and testing for SS in the future. However, I think you’re splitting hairs by saying it’s a $1500 (your example) benefit. If I were able to continue to get a $1500/mo cash flow that I could spend I would agree. But paying off the debt to fully own something I purchased is not a benefit. At best it’s the completion of the transation.

  6. Lord says:

    You are basically correct (effective meaning gross marginal, the actual tax difference). Some are in high tax situations and can benefit but most are not and do not. One can view it as an inflation hedge so long as you have a low rate. Means testing of SS has been with us for sometime though with up to 85% subject to income tax for moderate earners.

  7. Lord – Thanks for visiting and your comment (and for agreeing with me!) You are right about the current taxation of SS being a form of means testing but I am concerned that elibility for the benefits themselves will be based on inoome. That’s why I advocate owning assets in retirement (home, car) that can provide necessary living benefits (shelter, transportation) without needing taxable income to pay for those benefits.

  8. Stephen says:

    Reference: The Usual Tax Benefit Argument in Favor of Mortgage Debt? It’s Flawed

    It is easy to calculate your actual tax savings versus the interest savings by using your tax program (TURBOTAX/TAXPRO/etc.) by simply removing the mortgage interest from the income tax program and compare it to your liability with the mortgage interest. You can compare that to interest charged over the life of the loan. It still amazes me the number of folks that I know that does not understand the true cost of their homes (principle + interest over the life of loan).


  9. Stephen – Thanks for your visit and comment. Your suggestion about running the two scenarios in Turbotax is a good one but to complete the analysis they should also run a scenario with the standard deduction so they can see that difference as well.

  10. Atkins says:

    I am currently advising a lady who is getting a divorce. She is using a house her husband bought before the marriage (i.e. entirely his), so I explained the notion of imputed rent. He could quite reasonably reduce the alimony or child support by the amount of that rent’s market value. By taking money instead of value, she might choose to rent a less costly place.

  11. JimmyDaGeek says:

    Your arguments are interesting. I expect Roth IRAs will be taxed, just like Social Security. Next, there will be asset testing.

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