Hi everybody. Welcome to this edition of 5-Minute Finances. My name is Kyle Davis with Integrity Financial Group in Orlando, FL. Today we’re going to go through a quick lesson that I was taught, and it continues to be one of my favorite examples to use with my clients to illustrate a simple concept about mortgages. I like to call this one, “Happy House, Sad House” and it shows you an alternate angle that might help you with your overall retirement planning.
Alright, we have two couples entering retirement. Both have lived in Colorado for many years in a home worth 500k, and both have 401(k) dollars totaling 500k. Both couples decide they want to move down toFloridato spend their retirement years. They both sell their houses for 500k and move into their newFloridaresidences, which cost them 500k. All of the amounts are equal, and we do it this way to simplify the illustration. Obviously this situation would be rare, but it explains the point very simply.
Couple A took the 500k from the sale of their house, which is tax-free by the way (Sec 121 of the Tax Code) and paid cash for their new residence outright. They are free and clear with no responsibility to pay a mortgage. Couple B took the 500k tax-free from the sale of their house and invested it, instead using the 500k in the 401(k) fund to pay the mortgage down with.
At first glance, which situation would you prefer? A mortgage, or being debt-free?
Let’s take a real world look at what’s actually happening here. Couple A is going to be fully taxed on the 401(k) withdrawals as ordinary income, which means they are automatically going to have less money in their hands over time…up to 35% a tax as of 2011 depending on their marginal tax bracket…but they have no mortgage. The 401(k) will be for living expenses. Couple B is able to invest that money earning a conservative 6% compounding rate of return (which, by the way will generate about 30k a year in interest) and they keep a mortgage and use the 401(k) proceed to pay the mortgage down over time. The 401(k) is still fully taxable to couple B. However, because they have a mortgage and are paying mortgage interest on a primary residence, they get a home mortgage interest deduction on their taxes each year. So, they are paying tax on the 401k distributions, but they are getting a deduction from their interest payments on the house.
Now, what happens to Couple A if they need to get to the 500k in their home? They have to qualify for it…it’s not liquid. They have to go to the bank and home they can get a home equity loan. Their money is locked away in the house. If the house becomes valued at LESS than 500k, well, they’ve lost. Couple B has not pumped all of their money into this house. They are liquid. They still have the house, they still have the 401(k) and they still have the 500k tax free from the sale of their old house. What happens to couple B if the value drops on their home? Well, they have options. Their money is not locked away.
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