Retiring debt-free is the goal of many Americans. Increasingly, members of the baby boomer generation are retiring with substantial amounts of mortgage and consumer debt that will constrain their cash flow and lifestyle options during retirement. According to the February 2009 Federal Reserve Bulletin, the percentage of households age 65-74 with a mortgage on their primary residence increased from 32.1% in 2004 to 42.9% in 2007.
Cash Flow Options
The optimal solution is to pay off debt – all debt – before retiring and enjoy a relatively stress-free lifestyle as a result. On the other hand, cashing in all or a large portion of one’s nest egg just to retire the mortgage may not be a practical solution, particularly if doing so will generate a large immediate income tax liability. Imagine the amount of income tax that would be due by suddenly distributing $100,000 or more from a 401(k) plan or an IRA to pay off one’s mortgage balance.
When paying the mortgage off early is not an option, there are generally two other options available: 1) purchase an immediate annuity to cover the monthly payment, or 2) gradually cash in investment assets to make the payments. Other options are also available, but this article will focus on these two.
Make Mortgage Payments with a Fixed Annuity
As with most choices, there are pros and cons to using an annuity to make mortgage payments during retirement. Converting a portion of one’s investment assets to a fixed-rate immediate annuity offers the convenience of a continuous stream of fixed income payments that can be matched to the monthly mortgage payment. The annuity can also be held within an IRA to avoid the large one-time income tax payment that otherwise might be due if a lump sum were taken out of an IRA or qualified retirement plan all at once.
The annuity strategy is not perfect, however. Annuity payments generally last for the lifetime of the annuity owner, which means payments could continue long after the mortgage has been paid in full. These lifetime annuity payments may also result in additional taxable income to the retiree that is in excess of actual income needs.
On the other hand, living expenses and medical costs generally increase as one ages. The additional income that becomes available after the mortgage is retired may indeed be necessary. Perhaps the greatest risk from this strategy is the eventual death of the annuity owner. Lifetime annuity payments end when the annuitant dies, unless the annuity was originally established with a 10 or 20-year period certain payment provision. Having a sufficient amount of life insurance in place to pay any remaining mortgage balance is also a wise strategy.
Sell Stock and Other Investments to Raise Cash
Taking monthly or quarterly distributions from the retirement nest egg may be a better solution for some retirees, compared with the annuity option. Other retirement expenses not covered by pension or annuity income are likely already being paid from investment distributions. Factoring in the mortgage payment among the other living expenses is a simple matter. Projecting the necessary distributions of investment income and principal needed to cover these expenses is also straightforward.
A financial planner can easily calculate the likely timetable leading up to the exhaustion of investment assets over time, given the projected expenses and assumptions for inflation, taxes, and anticipated investment returns. Unlike the annuity approach, using stock and other investment assets to cover mortgage and other retirement expenses provides the opportunity for future investment growth as a hedge against inflation and rising medical costs.
No single solution is likely to be appropriate for all retirees. Individual requirements, resources, and circumstances are unique. With these factors in mind, it is highly recommended that retirees seek the counsel of a competent financial planner and consult with their legal and tax advisors before taking action.
 |
