Washington Post columnist Martha M. Hamilton was online Tuesday, May 15 at Noon ET to answer questions about making smart retirement decisions.

She was joined by Gene Amromin, an economist with the Federal Reserve Bank of Chicago and Jennifer Huang, an assistant professor of finance with the McCombs School of Business at the University of Texas.

This week, Martha's column focused on the decision between retirement savings and mortgage paydowns.

A transcript follows.

To read past Financial Futures columns, click here.

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Martha M. Hamilton: Hi, there, and welcome to our chat. We're well-stocked with expertise today, thanks to our guests, Jennifer Huang and Gene Amromin. They are two of the authors of the study I wrote about on Sunday about whether it makes more sense to prepay your mortgage or to contribute to retirement accounts. Gene is an ecoomist with the Federal Reserve Bank in Chicago and Jennifer is an assistant professor of finance at the University of Texas, my alma mater. I'll spare you a rendition of The Eyes of Texas in favor of answering your questions. Let's go!

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Rockville, Md.: Posting early due to a later commitment.

Martha - I was so happy to see a reasoned column on the pro's/con's of mortgage prepayment. I do think it was a little conservative for not considering the "investment option" a little more fully - over the life of a mortgage (15-30 years) the stock market has always seen positive returns in excess of today's mortgage rates (~10 percent vs ~ 6 percent). Another factor is "liquidity" - once you return money to the bank via pre-payment you can't get it back except by applying for a new loan or HELOC at whatever terms the bank decides to impose.

In general I am a great fan of Ms. Singletary (save, pay off credit cards in full every month, etc.) but she infuriates me by failing to acknowledge that the "right" debt (eg. long term, low fixed rate mortgage) is not "evil" (her words). I think your article summarized it best - if you can earn a better rate of return on your savings/investments than you are paying on your mortgage - NEVER prepay the mortgage.

It's all in the math, folks.

Gene Amromin: Thank you for your comment. The trick with considering a scenario where mortgage prepayment money is invested in stocks is that it changes the risk profile of your overall portfolio. Whether one wants to do this depends very much on your risk tolerance. Instead, we considered a purposely "neutral" scenario -- if you get to reallocate your savings without increasing the risk of your portfolio, should you do it? Hence, the conservative nature of our alternative investment choices.

Your point on liquidity is well taken. In fact, most of our academic colleagues mentioned that building up home equity is appealing to them because they can tap it more freely (yes, some of them were making "suboptima'" choices). Bu tthe reality is that HELOC and home equity loans are quite dependent on one's employment situation and selling a house outright to handle an emergency is a rather costly proposition.

You make a very good point about the "right" kind of debt -- the one that allows you to allocate consumption of expensive things like housing evenly over your lifetime. It's too simple to brand borrowing as evil without realizing that it palys a key role in enterpreneurship, home ownership, etc.

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Ellicott City, Md.: Hello Martha--I have a mortgage at 5.625 percent on which I still owe $62K. The interest I will pay next year on the mortgage is about $3K. I am fully invested in my employer's 401K and in my own Roth IRA. I make about $110K a year. I hold $100K of a stock that pays about a 5 percent dividend, and that is at a two year high right now. Finally, I plan to retire in about 2 years. Question: should I pay off my mortgage? Or, since I really want to pay it off, would I be an idiot to do so now? Thanks--Michael Brewer

Jennifer Huang: Hi Michael,

You will be doing the perfectly right thing to pay off your mortgage in your status, as you are already maxing out on your employer contributions. Our study focuses on those who are currently facing the choice of where to put an extra dollar of saving -- towards 401k or extra mortgage payments. We show that, for those households, they are generally better off putting that moeny towards 401k first. Once you maxed out on your 401k, paying off your mortgage is a perfect choice.

Martha M. Hamilton: Hi, Michael. Looks like you have every reason to do so. Thanks for your early interest in this subject which got me headed down the road to last Sunday's column.

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Kingwood, Texas: Someone at 55 with a long expectant life span (say 90+) who plans to retire soon with a very comfortable porfolio. At what age does it make the most sense to tap Social Security?

Martha M. Hamilton: I'd say wait until you're 70. Then your benefit will be bigger, which means everytime there is a cost-of-living adjustment, it's on a bigger base. It's the gift that keeps on giving. If you had a family history of early death, the answer might be different.

Gene Amromin: I agree with Martha -- after the age of 70, the Social Security benefit does not increase to reflect lower life expectancy. To learn more about this very important question you may want to follow up on research of Laurence Kotlikoff, who is aprofessor of economics at Boston University.

Martha M. Hamilton: And read an earlier column on this subject.

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washingtonpost.com: Your Age to Benefit (Martha M. Hamilton, Oct. 29, 2996)

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Laurel, Md.: Dear Guests,

The Bureau of Labor Statistics announced this morning that consumer prices (CPI) have increased 2.6 percent in the last year. In Martha's column, she calculated that she's paying 3.5 percent annual interest on her mortgage net of taxes.

Since she's effectively paying a 0.9 percent real interest rate, isn't just about any worthwhile use of money a better deal for her than paying her mortgage is?

washingtonpost.com: Consumer Inflation Moderates Slightly

Gene Amromin: You make an excellent point. We all often forget that true returns on investments are measured in real terms. However, this point applies to all types of investments -- mortgages as well as bonds and stocks. Hence, in comparing whether prepayment or 401k contribution makes sense, one may as well look at their nominal returns, as long as they have similar maturities. (TIPS are about the only asset class in U.S. that gives one information abuot the real rate of return)

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Kernersville, N.C.: I don't get it. You told Michael in Ellicott City that "Once you maxed out on your 401k, paying off your mortgage is a perfect choice."

This advice presumes Michael could not find an investment that pays more than his effective interest rate. Doesn't that contradict some of your advice and findings?

Gene Amromin: Let me clarify -- in the narrow context of mortgage prepayment and 401k accounts once a 401k is maxed out there is not much choice left. Of course, if one looks at taxable investment alternatives (which would also include paying down other, more expensive loans like credit card debt) then mortgage paydown is not an automatically correct decision. Sorry for being unintentionally misleading.

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Martha M. Hamilton: Here's a question from my e-mail this morning. what would yo advise?

What about someone who retired three years ago and still has a large mortgage payment? Should he/she withdrawal extra money from retirement funds to pay down the mortgage? This would mean paying taxes on more retirement withdrawals just to pay down a low interest mortgage. Did the study address this situation?

Jennifer Huang: It generally does not make sense to withdraw money from retirement funds to pay down mortgage, especially if the mortgage has low interest. One can compare the choices between paying off mortgage and leaving money in retirement accounts by comparing the rates you earn/pay on these two investments. The retirement funds earn before-tax return (say 5% if you invest in Treasury bonds), while the mortgage payments are tax deductable, hence you are paying after tax rate on it. If you have a 7% mortgage and are pay 40% tax (both state and federal), you are paying about 7*(1-.4)=4.2%. It still makes sense to put the money in retirement account. Our study indicates that, 4 out of 10 households who are prepaying their mortgage are making the wrong choice.

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Gaithersburg, Md.: In term of tax-arbritrage advantage, does it make a difference whether you save the taxes going in (401k) or out (Roth IRA), or does it all come out the same assuming equal tax rates?

Gene Amromin: If one assumes that tax rates in retirement will be the same as they are now, then the rates of return on 401k and Roth IRA savings are, in fact, equivalent. However, these two types of investment accounts differ in other important ways. For one, you can take money out of a Roth IRA for any reason (although you may have to pay an early withdrawal penalty). In contrast, you must qualify for a hardship condition or lose your job altogether to tap 401k savings before the age of 55. There are also differences in minimum distribution requirements, the risk of changes in tax law, etc. but the liquidity characteristics are probably the most important in the context of mortgage prepayment decision.

Jennifer Huang: Here is a simple example to see why 401k and Roth is the same assuming you have the same tax rate (say 40%) now and when you retire.

Assume you are investing for 30 years, with total return of R over the whole period. For each pretax dollar, if you put the money in 401k, you do not pay tax today, but will pay 40% tax towards the end. Hence, you have 1*R*(1-.4) = .6 R when you withdraw the money.

If you put the money in Roth, you pay the 40% tax now, hence, you invest 1*(1-.4)=.6 now. There is no more tax in the future. You will end up with .6 R, the same as the 401k case.

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Bowie, Md.: Home mortgage interest was made tax-deductible to encourage home ownership, which is arguably good for society.

But what's the justification for tax-deductible of home equity loans or lines of credit? Why should it be deductible to take one out to, say, buy a car, but the interest on a car loan isn't?

Martha M. Hamilton: Fair question, as is why should mortgage interest on a second home be deductible. They're nice--I've got one, but why should other taxpayers make it easier?

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Arlington, Va.: Hello and thanks for the chat. I want to carry over the "good vs. bad debt" debate to student loans. I have $90K in student loans with an interest rate of 2.875 percent for 30 years. You argue that it is sometimes not good to pay off a mortgage, how about student loans? BTW - the interest is non-deductible for me, my income is too high.

Martha M. Hamilton: I don't think paying off student debt with such a low interest would be a priority, but let's see what the experts think. I have a bit of that "debt is bad" reflex which made me occasionally think whether I should prepay my five yeare car loan at zero percent interest.I kept slapping that instinct down since it made no sense.

Gene Amromin: I agree with Martha. You can look at this in two ways, let's call them "cold-hearted" and "emotional". In case of the former, what you need to do is compare rates of return on alternative uses of money. If you can invest the money and earn a higher rate of return elsewhere, you'll maximize your wealth by not paying off this loan. But if you just can't stand the thought of still having a sizable student loan balance, then perhaps paying it off will make you feel better off (if not as wealthy). The choice thus really depends on one's preferences. The only thing we are suggesting is that one takes into account the financial cost (if any) of following the emotional tug.

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Washington, D.C.: What do you think about tapping into retirement funds for a downpayment on a home?

Gene Amromin: My personal view is that this is likely to be a good decision. Important as retirement savings are, one should not sacrifice everything for that goal. And the tax code is particularly helpful in the case of using 401k funds for a downpayment. Basically, if you are a "first-time" homebuyer (defined as "not having owned a home in the last 2 years), you can take money of your IRA without any withdrawal penalties. (You should check with a financial or tax advisor on taking the money out of a 401k type plan).

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Upper Montgomery: Read Sunday's column with quite a bit of interest as this is something my husband and I are struggling with. Short story is that we are both 37 years old and we bought a very reasonably priced home 10 years ago. Over the past 10 years we've been through a couple of major renovations, several refinancings, and we could now sell the home for nearly 3 times what we paid for it. We have about 9 years left on our mortgage. We're both maxing our employer contributions on our 401(k) plans, have other investments, and 529 plans for our children's education. Would we be better off refinancing with a 30 year mortgage and aggressively saving for retirement? I know it's difficult to predict what the housing market will be like in 30 years, but part of our strategy has been to own the home free and clear and sell it upon retirement.

washingtonpost.com: Homeowners' Get-Out-of-Debt Instinct (Martha M. Hamilton, May 13)

Jennifer Huang: It is great you are maxing out on your employer contributions. Our study focuses on those who are currently facing the choice of where to put an extra dollar of saving -- towards 401k or extra mortgage payments. We show that, for those households, they are generally better off putting that moeny towards 401k first.

Martha M. Hamilton: It's an issue lots of folks are struggling with.

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Arlington, Va.: What do you guys think about the research that found brokerage firms advise their clients to save more than needed for retirement? More money under management means more management fee income, and its hard to argue with "more is better", right?

Gene Amromin: You are probably referring to work by Laurence Kotlikoff of Boston University. What the right amount of retirement savings is depends crucially on the assumptions one makes about rates of return, tax environments, the future status of Social Security and Medicare, bequest treatment and, importantly, the desired standard of living. As you can see, there is quite a bit of uncertainty built into every one of these crucial elements. This is a rather long prelude to saying that very reasonable people can disagree about how much needs to be saved even in the absence of any ulterior motives.

Having said this (and this will betray my research bias), I take Kotlikoff's work very seriously. His assumptions are transparent and incredibly detailed, and his software can be downloaded and analyzed by skeptics. You may be also interested to look up some recent work by Karl Scholz and co-authors from the University of Wisconsin, who find that the much-maligned American household is saving very close to what would be "optimal" in their model of lifecycle consumption and savings decisions.

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Seattle, Wash.: My goal is to retire really early, like 45-50. I am 26, and have $35,000 between a 401(K) and Roth IRA. I make about $60-$70K. I don't know if I will make it, but my question is should start putting additional money into taxable accounts, as there are penalties for withdrawing early from the retirement accounts. I'm also wondering at what age you can withdraw from a 401(k) and Roth IRA without penalty?

Thanks!

Martha M. Hamilton: The penalties drop off when you're 59.5. Maybe you should consider a mid-career break at age 45-50 and then go back to work. If you retire at 45-50, you've got a lo-o-o-ng time in front of you.

Jennifer Huang: I agree with Martha - if you retire at 45, you have a long time ahead of you. You generally need some money in your taxable accounts in addition to your 401k savings to support you through retirement - through additional savings, rather than from cutting back on your current 401k savings now. If you face a choice between 401k and taxable account saving, putting money in 401k usually dominates as long as you can leave the money in the 401k account for 5-10 years (the before-tax compounding will be sufficient to offest the 10% penalty). Given your young age, 401k always dominates.

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Southern Maryland: We will have paid off our mortgage by retirement. Our mortgage payment will probably be replaced $ for $ by a monthly health insurance premium.

Martha M. Hamilton: You make a really good point about one of the major and sometimes unanticipated expenses in retirement. Health care costs can make short work of any extra dollars you have.

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Atlanta, Ga.: You said:

If you can invest the money and earn a higher rate of return elsewhere, the point is - MOST people -don't- save the money that they would have been doing otherwise with (i.e., paying off debt). MOST people will use the extra money to go out to dinner more, or buy that expensive blouse, or whatever.

That's one argument for putting a little extra towards the debt. MOST PEOPLE aren't going to save it. That is clear over and over again when we hear that Americans are terrible savers. It is said because it is true (most people are -negative- savers).

Gene Amromin: In our study, we felt comfortable talking about alternative investments because the households we were looking at were already saving -- by building up home equity. Thus the question was really can you channel these existing savings elsewhere to increase your wealth. What you probaly have in mind is that if folks don't have the commitment of a 15-year mortgage they will end up not "saving" this money. This may well be true, but were not willing to assume that.

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Oakton, Va.: Regarding 401K vs Roth IRA rate of return - I'm many many years from retirement, so maybe I don't understand this, but assuming you are retired and in a lower tax bracket, wouldn't your tax rate be lower at that time as opposed to when you made the original contributions?

Gene Amromin: This is a likely scenario but the big question mark is just what the tax rates will be when you retire. If one takes projections of federal debt and Medicare/Social Security seriously, then these programs will either have to be scaled down dramatically or financed through higher taxes.

Martha M. Hamilton: It also depends on when you started the Roth. They're often a good choice for young people just starting out and paying relatively low taxes. And whether you have income from other sources in retirement, such as a traditional pension.

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McLean, Va.: Should I pay off my 5 7/8th mortgage with the cash that is in a money market account? I'm in the 7th year of a 15 year mortgage and have other assets. I itemize deductions but don't get full credit for them on Schedule A.

Jennifer Huang: If the comparison is between your mortgage (which is not fully tax deductable) and money market account (which earns much less 5 7/8), it is defintiely wise to pay off your mortgage early.

Our study focuses on the comparison between mortgage and tax-deferred investing, especially for those who can fully deduct their mortgage interest. For example, if you mortgage is 6% and you can deduct 40% tax, you are effectively paying 6*(1-40%)=3.6%. If your tax-deferred investing can earn more than that (say 5%), it will make sense to put money in 401k. But if you are leaving the money in taxable account, then you only earn after-tax return. It generally does not makes sense to hold on to your mortgage since your mortgage rate is generally higher than the interest rate you can earn.

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Annapolis, Md.: I'm a recent Federal Gov. retiree (FRS) with a substantial Thrift Savings account for which I need to make a decision on annuitizing, cash out to and IRA, or a stream of payments. I'm pretty conservative in my investment philosophy at this point in my life. My remaining mortgage is about $90,000. It seems to me that paying this off (next year at a lower tax rate) beats putting these funds into an annuity. I have a pretty good cushion for emergencies, but need to reduce the mortagae or start pulling some funds for the monthly expenses. My facts are a bit different in the article, so I'd appreciate your comments.

Gene Amromin: Thank you for your question. Annuities are a little more tricky in this context, primarily because annuity conversion factors (i.e. rates of return) are not very transparent. Still, you can go through the following exercise -- get two quotes from your Thrift plan manager, one of which would give you the monthly payment if you annuitize your full Thrift balance, and another that would give you the payment for the balance less 90K used to pay off the mortgage. By taking the difference, you'll see how much you're giving up in retirement income flow by getting rid of the mortgage. This isn't a totally foolproof exericse, since your mortgage may get paid off in 10 years, whereas your expected annuity payments will probably cover a much longer period. But this is a first easy step. Your Plan manager probably provides a counselling service, and I would suggest you talk to them as well.

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mortgage prepay: I think it's important to look at the mortgage prepay question as one that is influenced by your own life and career needs. Within five years, I look forward to moving full-time into a career with large but very irregular chunks of income. So, since I have an 80/20 style mortgage, I am prepaying the 20 with all speed in order to lower my monthly fixed costs and better accommodate my future cash flow. I have no doubt that a lot of those big income chunks will go to prepaying the 80 as well. I'm still in my 20s and I am investing in my 401(k) to get the full employer match. I know that investing the max in my 401 (k) would be optimal, but I'm trading some future returns for the flexibility to move into a more lucrative career. Also opted for a cheaper, smaller home to make this work.)

It's worth analyzing the situation and deciding on your own best scenario, rather than taking anyone else's numbers. Michelle Singletary is right, in that less debt = more freedom, and so are you, that prepaying deductible, low-interest debt is stupid while higher-interest debt remains, and financially less beneficial when tax-deferred accounts are available.

Jennifer Huang: You make an excellent point about taking into account one's individual situation before deciding between mortgage payments and 401k savings. We do not argue that putting money in 401k is always the winning strategy. Indeed, for households with very high mortgage interest rate, it may very well be wise to pay off mortgage first. Using the Survey of Consumer Finances data, we find that for 4 out of 10 households, depending on their individual mortgage rates, it makes sense to put money in 401k savings first.

On the other hand, home equity is a bit over-rated as a safe net for households that are concerned about liquidity risks, like your concern for less stable income in the future. Home equity line of credit is usually not available exactly when people need it the most - when they lose their jobs. On the other hand, you can usually tap into your 401k savings for financial difficulty (after a 10% penalty, but your tax rate will generally be lower in these situations.)

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Martha M. Hamilton: We had many, many more questions than we were able to get to today. Lots of interest in this subject. I have a request for online chatters on another subject: If you are a smalll business owner struggling with the issue of how to provide retirement coverage to your employees, I'd love to hear from you at hamiltonm@washpost.com. some pension experts have ideas about how to make this easier, and I'd like to write about your reaction to some of their ideas. As usual, I thank you for your questions and interest, and I thank Gene and Jennifer for bringing their tremendous expertise for our benefit.

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