My husband and I own two cash-positive rental properties with a combined mortgage balance of $260,000. Our 401(k) accounts are worth a combined $1 million. We will both retire next year and will draw Social Security of about $4,000 per month.
Should we pay off both mortgages with 401(k) money and supplement our retirement with net rent receipts of about $2,500 per month? Or, would it be wiser to pay off our primary residence mortgage at $270,000?
Congratulations on building a sizable nest egg. You have quite a bit of money in play here, and while your question seems rather straightforward, the answer is a bit more complex.
Given that you are savvy real estate investors, we’re going to assume that the loans on those properties are at low interest rates. If you pay off these debts, all the income you receive from the properties will be taxed as ordinary income. You may also get depreciation benefits from the properties, and both the loan and the depreciation allowed together lower your annual tax bill to the IRS.
Just a thought, but you might find that lower tax bill to be quite helpful during your retirement.
As you take money out of your 401(k), you’ll have to pay (remember, qualified retirement account withdrawals are considered to be taxable income). If you don’t have the deductions on your current residence and your investment properties, you may jump up a couple of tax brackets and realize too late that you made a mistake.
You should sit down and calculate what your tax situation would be if you paid down some or all of your loans. You’d have to compute first how much tax you’ll owe on the 401(k) distribution and then how the loss of the deductions on the loans will affect your federal income taxes. Once you’ve done that, you’ll then see if paying all those taxes now is to your advantage.
From our perspective, it seems that you might be better served if you keep your 401(k) intact and keep paying down your loans on schedule.
If you’re doing well with those 401(k) investments (or even if your return is about the same as the cost of the loan interest payments), you’ll be ahead. If you refinanced these loans and have interest rates that are around 3 to 5 percent, those rates are great. You’ll have many years in retirement and you don’t need to rush out and pay down these debts unless you truly benefit from paying them off.
For example, if your home mortgage interest rate is 10 percent and you have been unable to refinance, we could see how using your retirement money to pay down some of that date could be beneficial to you now and in the long run. But at 4 percent, that calculus flips.
A fee-only financial planner (try to hire one by the hour or for a flat fee for consultation) could help you assess the net effect on your finances. Your tax preparer can help you run through various tax options.
Ilyce R. Glink’s latest book is “Buy, Close, Move In!” If you have questions, you can call her radio show toll-free (800-972-8255) any Sunday, from 11 a.m. to 1 p.m. EST. Contact Ilyce through her Web site, www.thinkglink.com.