When planning for retirement, your investment portfolio tends to be the focal point. But your house may represent a significant store of wealth on your balance sheet, too, particularly if you have lived in it for a long time. Moreover, it also might represent a significant ongoing expense. Indeed, data from the Bureau of Labor Statistics show that housing costs, excluding mortgage payments, are the largest spending category, in aggregate, for Americans age 65 and older, representing 30% of total spending.1
To be sure, your house is not just another financial holding, like the securities in your investment portfolio. After all, your house is your home—a place that may be filled with fond memories that provide a strong emotional return on investment. Plus there are practical considerations for retirees: perhaps you live near your grandkids and family and friends, quality health care facilities, or enjoyable cultural resources. But at the end of the day, your home is an asset, and perhaps a large one, that can consume a substantial portion of your ongoing cash flow; therefore, it should be managed with as much care and diligence as your other financial resources.
In this newsletter, we review some of the more frequent questions our retired and near-retired clients ask us as they seek to fit home ownership into their overall retirement plan. Bear in mind that these conversations occur as part of our role as financial planning “generalists”; often, our clients appropriately consult their other financial professionals as well—such as bankers, attorneys, and accountants—before making any decision regarding their home, as the impact can be far-reaching.
Should I Pay Off the Mortgage?
We’re often asked whether it makes sense to eliminate, or at least significantly reduce, mortgage debt prior to retirement. Mortgage debt is considered a fixed expense (and by fixed we mean nondiscretionary, regardless of whether the interest rate is fixed or variable). Of course, reducing your overhead in retirement can put less strain on your investment portfolio, making it easier for your assets to last longer. This can be particularly valuable during weak market environments, when it may be necessary to scale back on your expenditures, at least temporarily.
But it likely makes sense to pay down your mortgage only if you can do so with cash held outside of retirement accounts. Distributions from traditional IRAs and other tax-deferred vehicles are taxed as ordinary income, so it is prudent to limit these to required minimum distributions—unless you have deductions, such as significant medical expenses, so that additional distributions have minimal if any tax consequence. Roth IRAs, which contain money that has already been taxed, provide tax-free compounding and are thus a good bucket for stock exposure (i.e., growth assets); therefore, you could be incurring a potentially significant opportunity cost if you tap these assets at the onset of retirement in order to pay off a mortgage.
Additionally, maintaining a healthy cash savings balance, particularly when you first enter retirement, can provide valuable peace of mind as you figure out your ongoing expenses during this new phase. However, once you have settled into your new lifestyle, you may find that you have built up a larger cash cushion than makes sense, particularly if you have a sizable mortgage on the other side of your balance sheet ledger.
Indeed, from a strict financial standpoint, the decision boils down to whether the potential earnings on the assets you would use to pay down the mortgage might exceed your mortgage rate, on an after-tax basis. This is typically a no-brainer when it comes to excess cash, especially given current low yields. To be sure, adding this excess cash to your investment portfolio (i.e., stocks and bonds) may end up returning more than the mortgage rate over time, but the margin of outperformance may be lower, especially if you are retired, because at this point, you will likely have a more conservative asset allocation, meaning a heftier bond exposure. (While bonds provide lower expected returns over time compared to stocks, they do offer more stability.) Indeed, paying down a mortgage is like investing in a bond, albeit one with no credit/default risk, as it provides a guaranteed rate of return. Every dollar used to pay off the mortgage effectively “earns” the interest that you otherwise would have paid over the balance of the mortgage term.
Finally, another reason you might be reluctant to pay down your mortgage is that you do not want to forgo the tax deduction on the interest. But for those who are nearing the end of their mortgage amortization term, interest probably represents only a small portion of the remaining payments. Moreover, whatever the deductible interest amount may be, your monthly payment is still an out-of-pocket expense—and one that may still exceed the earnings on your liquid assets, even on an apples-to-apples, after-tax basis.
What Are the Financial Ramifications of Selling My Home?
While the financial consequences of a home sale can be multifaceted, affecting your living costs and overall financial safety net, a common query we hear from clients is actually tax related. Specifically, despite rules that have now been in place for 20 years, we see a fair amount of confusion about how capital gains on home sales are treated. So let’s first review the current tax laws.
Prior to the passage of the 1997 Taxpayer Relief Act, if you sold your home at a profit, you were allowed to roll over the proceeds of the sale into the purchase of another home to postpone any capital gains taxes, assuming you purchased a new home within two years of the sale. The old law also allowed individuals over age 55 to claim a once-in-a-lifetime exclusion of $125,000, in terms of sheltering taxable capital gains resulting from the sale of the home.
Since 1997, however, if you sell your principal residence for a profit, up to $250,000 is exempt from capital gains tax. This exemption is $500,000 for married couples filing a joint return.
In order to claim the maximum exclusion, though, you have to meet so-called ownership and use tests as set forth by the IRS:
- You must have owned the house for two years, and
- You must have lived in the house as your principal residence for two of the last five years, ending on the date of the sale.
Notably, the two years’ residency does not have to be consecutive; you simply must have lived in your home for a total of 24 months—in no particular order—out of the five years prior to the sale. Additionally, you can claim this exclusion on multiple sales, as long as each home was your principal residence for at least two of the previous five years.
If you don’t meet the eligibility test, you still may qualify for a partial exclusion of the gain if you moved because of work, health, or an unforeseeable event. Relief is also offered to those who work for the government as uniformed or intelligence personnel or are with the Peace Corps.
To minimize taxable gains beyond the exemption amount, it is important to track your home’s cost basis. This is not simply your purchase price plus certain expenses associated with the sale. Your cost basis also includes the cost of improvements—but not repairs—such as additions, new roofing, or new plumbing.
Despite the exemption threshold, you still may have a taxable gain if you sell your home, which admittedly is the case for many of our retired clients who have owned their homes for decades, particularly those in the Bay Area. And while it may make sense to sell your home, for financial and other reasons, there may be a case for deferring the sale if you are able to—namely, for couples where one spouse is in poor health and may have a short life expectancy. This is because upon the first spouse’s passing, the widow or widower may be entitled to “step up” the home’s cost basis to either half of or the full fair market value (depending on state of residence and particular asset titling) as of the date of death for the decedent, or six months thereafter if using an alternate estate valuation date.
The surviving spouse also should be aware of the tax treatment of any consequent capital gains, after the home’s cost basis has been “stepped up”—specifically, whether he/she is still entitled to the full $500,000 joint exclusion or just the $250,000 amount available to single taxpayers. If both spouses met the two-out-of-five year use test at the time the spouse died, the survivor should qualify for the $500,000 exclusion if the survivor does not remarry and sells the house within two years. Otherwise, the $250,000 limit applies.2
Should I Tap the Equity in My Home?
Perhaps you want to stay in your home but desire, or need, to tap the equity. Granted, this issue does not arise as frequently as the other two we’ve discussed, as our typical client is fortunate to have sufficient liquid/investment resources to fund their ongoing living expenses. With that said, we thought it was worth discussing, given broader general interest.
Perhaps the most oft-cited means of tapping home equity, aside from downsizing, is a reverse mortgage. If you are 62 or older, this allows you to borrow against the value of your home without paying back any of the loan during your lifetime; rather, the loan is paid back when you move permanently, or by your heirs after your death. The money received is tax-free, and the total amount owed, including all accrued interest, cannot exceed your home’s value. Regardless, a reverse mortgage is typically considered a loan of last resort, because it can mean fewer assets for the homeowner and heirs, as the bank owns more of your home each day as interest accrues.
Reverse mortgages have been in existence for over 50 years and have been the subject of a fair amount of controversy, due to high costs and abuse by some lenders. More recently, however, they have had more regulatory oversight. In fact, nearly all of the reverse mortgages issued today are federally insured, and are known as “Home Equity Conversion Mortgages,” or HECMs. Even so, borrowers need to be very deliberate about the costs, benefits, and financial implications of a reverse mortgage. Correspondingly, homeowners are required to meet with a government-approved counselor to apply for an HECM.
Lately we have been noticing an increasing number of articles promoting the potential benefits of establishing a reverse mortgage line of credit (otherwise known as a standby reverse mortgage), particularly at the onset of retirement. This is because the earlier the line of credit is established, the more the retiree can likely draw in the future; the available maximum borrowing amount automatically grows over time, at the same interest rate being charged on the line of credit, for any unused balance. Thus, the line could provide a flexible and growing reserve of funds to help manage cash flow during the course of retirement. However, the same cautionary considerations cited for reverse mortgages still apply. Interestingly, while the subject of reverse mortgages has come up occasionally in our conversations with clients, we do not know of any who have used them, either as a line of credit or in a lump sum.
Another form of tapping equity, which is a bit less known, is called a real estate equity investment contract. Under this relatively new arrangement, you receive a lump sum in exchange for giving the capital provider rights to a part of your home’s future appreciation. Unlike a reverse mortgage, this is not a loan; rather, the capital provider becomes a fellow equity shareholder in your home. But like a reverse mortgage, this arrangement seems most suitable as a financing option of last resort, for those who may be “house rich” but “cash poor” and need to pay off a one-time expense, such as a large medical bill. As far as we know, there currently are just a handful of companies issuing these contracts. Again, although we’ve been asked about these arrangements, we are not aware of any clients who have actually used them. Either way, homeowners should tread carefully; as one company in the business, Unison, admonishes in its own disclosure statement, “We cannot overemphasize the importance of having a full understanding of the features of the agreement before entering into it.”
In the end, your home may be where your heart is, but it also is central to some key economic calculations your mind must contend with over time. As with many other financial considerations you weigh as you prepare for retirement, home-related decisions can be more complex and nuanced than they may appear to be on the surface. Oftentimes these deliberations are a balancing act, and thus it is important to understand the pros and cons to make an informed decision.
Regardless, we are happy to act as a sounding board on any concerns or questions you may have regarding the financial aspects of your home. Ordinarily it makes sense for us to advise you in tandem with the other members of your wealth management team. After all, these issues can be broad in scope, potentially impacting not just your investment portfolio and cash flow, but your tax returns and estate plan as well.
1. By comparison, health care is the third largest category for this age group, at 12% of spending, although it does have one of the highest inflation rates among all categories.
2. For those seeking more detail about home ownership and use tests, as well as determining cost basis, information is available in IRS Publications 17 and 523.