Everyone knows one of the great benefits of home ownership is the tax advantages that come with the ability to deduct mortgage interest and property taxes. In the past, it was common for Americans to buy a house, stay put for 30 years, and retire their mortgage before they retired from the workforce.
Not anymore. Increasingly, Americans are carrying mortgage debt into their retirement years. More than half of those on the verge of retirement — those 55 to 64 — still carry mortgage debt, according to Pamela Villarreal, senior fellow with the National Center for Policy Analysis, a think tank.
Retirees have many reasons for carrying mortgage debt. If their mortgage payments are small, they may not consider it an issue to pay them in their retirement years when their annual income may be reduced. But it could have a substantial impact on their long-term wealth, Ms. Villarreal explains in a new policy brief “Retiring Soon? Pay Off the House First.”
Ms. Villarreal used the NCPA's handy new State Tax Calculator, which compares the tax burden from state to state, to illustrate her point.
The next time you meet with clients who are planning to relocate in retirement, you might want to give this calculator a spin. This customizable tool measures the amount of lifetime spendable income after taxes and housing or rental expenses. The calculator accounts for federal and state income taxes, median property taxes, and state and local average sales taxes for each state.
Consider a 64-year-old New Jersey resident who plans on moving to Texas — a state with one of the lowest tax burdens thanks to no state income tax — and retiring at 65. Assume he has $500,000 in tax-deferred retirement savings and $75,000 in regular savings — all factors that you can input into the calculator. He currently earns $75,000 a year, and has a home in New Jersey valued at $300,000, with $50,000 left on his mortgage to be paid off in five years.
If he moves to Texas, purchases a house for the same amount ($300,000) and assumes a $50,000 mortgage for 10 years, his monthly payments will be low — about $500 a month at a 4% fixed rate. But he will gain only $79 a year in discretionary income for the rest of his life, according to Ms. Villarreal's analysis. Assuming he lives to age 100, his lifetime gain will total $3,404.
If, instead, he uses the proceeds from the sale of his previous home to purchase a $250,000 home for cash, he will gain an additional $2,318 in annual discretionary income, resulting in an additional lifetime wealth accumulation of $99,334, she concludes.
Two factors are at play. First, despite Texas' overall low tax burden, its median property tax rate is about the same as New Jersey's. Though property taxes and mortgage interest payments are both tax deductible, the breaks are not enough to reduce his federal tax burden and increase his wealth. Thus, purchasing a less expensive home and paying for it in full increases his wealth by reducing property taxes and interest payments.
“Although property taxes will still have to be paid with or without a mortgage, the taxes may be reduced if the homeowner downsizes,” Ms. Villarreal explained in an e-mail. “The State Tax Calculator factors in the differences in median property tax rates for each state,” she wrote.
Do higher home values translate into more wealth? Consider a couple earning $200,000 a year who plans to move from New York to the lower tax state of Florida. Both spouses are 64 and will retire in a year. The couple has $1.5 million in retirement account savings and $200,000 in regular savings. They own a $400,000 home in New York with a $150,000 mortgage balance left to pay over 15 years.
If they move to Florida, where tax rates are lower, and purchase a house for the same price as their New York home with a $250,000 down payment and a 15-year mortgage, they will have an additional $3,651 to spend each year and an additional lifetime accumulation of $156,415.
However, they can more than double their additional discretionary income each year to $9,513 by downsizing to a $250,000 home and purchasing it outright. Their additional lifetime wealth would be more than $400,000.
Mortgage interest may not concern some retirees, as it is a tax-deductible expense. But Social Security benefits and retirement account income could put them in a lower tax bracket than while they were working. Itemizing may not be the best way to reduce their tax liability.
For 2014, the standard deduction on federal income tax returns is $6,200 for singles or marrieds filing separately and $12,400 for married couples filing jointly. In addition, taxpayers 65 and older are entitled to an extra standard deduction of $1,200 per person. Consequently, taking the standard deduction could be more valuable than itemizing, so paying interest on a mortgage gives the homeowner no tax advantage.
When considering a move in retirement, whether to another home or another state, pre-retirees should look at the pros and cons of carrying a mortgage, Ms. Villarreal argues. Paying down higher-interest debt, such as credit cards, should take first priority. But those who have only mortgage debt should think carefully before taking on another mortgage or extending their existing one.