I came across a couple of investors this week who are a few years away from retirement. Upon retirement, one spouse would receive a substantial bonus that would pay off their house, allowing them to enter retirement with no mortgage. But the closer I looked at their situation, the more I realized it made better financial sense for them to do a cash-out refinance of their home, take on a new 30-year fixed-rate mortgage and retain their windfall for liquidity during retirement.

What the investors heard was “cash out their equity and invest in the stock market.” Needless to say, they thought I was crazy. So why would I give this advice? Let’s explore their situation more closely.

This couple had a modest after-tax investment account and the bulk of their wealth invested in tax-deferred retirement accounts, including IRAs and 401(k)s. The minute they begin to pull money from these accounts for living expenses, their withdrawals will be taxed at ordinary income rates. So, if they need $80,000 from tax-deferred retirement accounts for living expenses, they’ll likely need to withdraw closer to $112,000 to pay both federal and state income taxes. That could deplete their retirement funds faster than they planned.

Furthermore, this couple was still trying to shift their mindset into the spending phase of their lives from the accumulation phase they have been in. It is easy to not care about carrying a mortgage when there is income coming in each month. But as they begin to pull money from their retirement savings, that mortgage looks like an albatross. They wanted to use the retirement bonus to let that bird go.

I pointed out that the after-tax bonus money could be put to better use. What I recommended was they consider a cash-out refinance. The couple had plenty of equity in their home, and they intended to stay in that home throughout retirement. With the recent interest rate cut by the Federal Reserve, 30-year mortgage rates were around 3.5 percent. That is a very cheap rate to borrow 30-year money.

With the bonus and the after-tax proceeds from the refinance, this couple could ladder out fixed-income bonds for the next 10 years, covering the mortgage, property taxes, and living expenses, thus delaying how soon they would need to tap their tax-deferred investments. Essentially, this couple could have 10 years of mortgage payments set aside, mostly protected from any economic recession that may or may not happen—unlike the assets in their retirement accounts. Not only should this minimize the taxes they’ll pay, but they could also potentially get a mortgage interest deduction if they itemize their federal returns.

After 10 years, this couple would be taking required minimum distributions; therefore, during the 10-year span when they are living off after-tax money, paying minimal income tax, they should be able to take withdrawals from their tax-deferred accounts, potentially paying tax at a lower marginal rate, and filling up their rolling 10 years of liquidity needs.

While this situation was unique to this set of investors, the lesson is to really take a look at the math before deciding to pay off your mortgage before retirement. Your cash flow may benefit from carrying a mortgage during retirement. You may not be able to pay the taxes, keep the lights on, or pay for food if your cash is tied up in illiquid investments.

William G. Lako, Jr., CFP®, is an Executive in Residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial and a co-host on Atlanta's longest running, most respected financial talk radio show "Money Talks" airing Saturdays at 10 a.m. on AM 920 The Answer. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.


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