Nothing great in life is accomplished without the assistance of strangers. This holds true for personal finance, where leveraging two forms of OPM—other people’s money and other people’s mistakes— often provides the surest route to success.
This embrace of debt always sits uneasy in middle America. We’re trained from birth to abhor debt. Like primal instincts that prompt us to jump when we hear rustling in bushes in the small chance that it really is a venomous snake or something worse, this debt aversion is no doubt an adaptive trait for people with low levels of assets and low levels of income. But just as modern realities have changed smart retirement income planning from its former fetish of living on the income generated from conservative assets, low interest rates combined with relatively large investment accounts change the smart approach to debt.
In this spirit, here are four new rules of debt for the astute pre-retiree to adopt.
Your mortgage is not a problem.
Chevrolet, baseball, and apple pie. It’s in this tradition of good wholesome American living that people aspire to be mortgage-free. I’m all for paying off mortgages, given the right set of facts. But the mortgage-free retirement is a relic of the past. In many instances, it’s no longer necessary.
In the old world, our grandparents and parents purchased a house, took a 30-year mortgage with a substantial interest rate, and paid this off in a straight line.
One house, one spouse, one mortgage. This is a great plan. It reduces expenses during peak earning years, creates money for saving and investing, and eliminates an expense in retirement, namely the principal and interest payment. (Note that you always will have a house payment in the form of taxes and maintenance. In this vein, the principal is typically not an expense, but just an internal financial transfer.)
It’s not likely your plan, however. My clients who approach retirement with mortgages usually have good financial reasons for doing so. Today’s rock-bottom interest rates, elevated home values, and aggressive mortgage industry transformed the mortgage from a one-and-done event into a flexible financial tool. When confronted with large expenses that could not be saved for, such as rapidly escalating college tuition bills, the best place to get the money was to leverage the house. Due to government policy, this strategy combined rock-bottom rates with the potential for tax deduction and became the smart money move.
Even folks who didn’t need the cash out made the smart play to refinance their liability as rates dropped, freeing up cash flow for retirement investing. Lowering a mortgage payment and putting the funds in a retirement plan can be a double play, gaining from the difference between paid and earned interest rate as well as from the substantial income tax deduction on home mortgage interest.
So, as we sit in the waning days of 2021 with 30-year mortgage rates hovering at 2.5 percent, the required payment on each $100,000 of debt is a mere $395. Of this, $187 is principal in the first payment. Principal isn’t even a real expense, but rather a transfer from your bank account to your home equity. So the planning issue is, can you easily make the payment? If you answer yes, you can relax. It’s not a problem. Retire with a mortgage. It’s the smart move.
Interest is way cheaper than taxes.
Like most people, I hate to say no. I’m a lover not a fighter. I find honey usually gets better results than vinegar. Yet, one place I have no problem putting my foot down is when pre-retirees tell me they plan to pay off their modest mortgage, $100,000 or more, with a withdrawal from their retirement plan.
Friends don’t let friends drive drunk and fiduciary advisors don’t let clients pay off low-interest mortgage debt with high-tax assets. I don’t allow it. I argue. I reason. I fight. I throw my body across the door to block the exit.
Paying off a low-rate mortgage from a pre-tax retirement plan is the financial equivalent of remaining on Mount Saint Helens when you know the volcano is set to erupt. Not smart. If interest is 3 percent and combined federal and state income taxes approach 30 percent of the withdrawal, you should view paying the bank as a gift from on high.
It’s understandable that you want to be “debt free,” but understand that the cost is the interest. The principal is simply moving money from one of your pockets to another, akin to transferring your wallet from your back to your front pocket. It makes you feel good, but that’s it.
Fasten your seatbelt. I’m going to apply this financial logic to places you may not want to go.
Finance the car, boat, kitchen, or motor home.
Assuming that your source of funds available for large purchases is your pre-tax retirement plan, I strongly urge you to finance the new or certified used car at low interest rates. If you’re making substantial purchases at Home Depot to keep that house of yours well-maintained and up to date, I urge you to take the zero percent or low percent interest offer on the house credit card.
Again, the interest is usually less expensive than the taxes. Way, way, way less. It does depend on the person, however.
Examine where you sit in the tax brackets. Make sure you optimize your 12 percent or 22 percent bracket. You can accelerate the payoff of the debt as your income tax optimization permits. You are not hostage to the creditor’s repayment schedule. But use other people’s money. Rely on the kindness of strangers. It’s smart.
Your retirement plan may be the place to turn for funds.
Let’s go back to the basics. The cost of debt is the interest payment. The principal is something that you got advanced and presumably added to your happiness if not your net worth. The debt scolds will tell you never to borrow against your retirement plan, making up tales of being double taxed and risking a degraded future.
In some cases, they are right. I’ll get to that in the next rule. But in others, they are certainly wrong.
If you are approaching retirement with high-interest debt and decent income, it may be a smart move for you to leverage your employer-provided retirement plan at a much lower rate and kill the high-interest liability.
Again, the cost of debt is the interest paid, so a credit card at 15 percent costs $125 a month per $10,000 versus $33 per $10,000 for the same amount in a 4 percent 401(k) loan. And in the latter case, you pay the funds back to yourself. The real cost is lost investment return that the money would have earned if left invested. It’s a potential double digit return!
Don’t fret about bringing this liability into retirement. At this point, you may have two options to dispose of it responsibly.
First, you can keep paying the loan if the plan allows it. This allows you to finesse the liability to zero at the lowest possible cost.
If not, some plans will cancel the debt a few months after you retire, treating the payoff as a taxable distribution from the plan. Timed correctly, this can be at a much lower income tax rate than while working.
You will need to do smart planning around this. Make sure the debt is canceled in a low-income year. You may have to retire in the fourth quarter to accomplish this. Taxes operate on a calendar year, so a few weeks can make a huge difference in the rate paid.
You may want to keep the pressure on.
Now it’s time for me to backtrack. I am both a student and a lover of people and my strategies accommodate human nature rather than abstract notions of the just and good.
Some of you are happy carrying a few dollars in high-interest credit card debt.
I know this from years of experience.
You’ll tell us financial people what we want to hear, proclaiming that you want to pay your debt down to zero. Yet you are in fact fine with some affordable level of revolving debt. Your actions make this clear.
It’s like my target weight. I’ll tell you I want to get back to 165 pounds. When I’m 190, I’ll make the necessary moves to move the needle south. But at 180 or so, I’ll stall, and that needle will start moving north.
As my dad used to lecture, show me don’t tell me. Economists call it revealed preference.
If your comfort level with debt is $10,000, for example, it is a losing strategy to pay it down with asset withdrawals as you’ll only get right back to your comfort level. At that point, you’ve lost the asset and the debt is right back where it started. It’s better to pay the reasonable price to keep the pressure on. I learned this lesson in the first year of practicing as a financial advisor.
A couple with debt kept professing a desire to be free of it, whatever it took. I’d put together detailed plans to destroy the professed albatross. They’d knock it down a little by the mid-year review, but it’d be back in full fury for the annual checkup. At year three, I gave lip service to debt reduction and started an investment program to build wealth. A few years later, the wife died and most of the debt with her. The investment assets created are still providing support nearly 20 years later.
In a perfect world, we’d all arrive at retirement with a debt-free balance sheet. No argument here. It’s never smart to let the perfect be the enemy of the good or the good enemy of the good enough. When it comes to debt, you can carry some and be financially independent at the same time.
Michael Lynch CFP is a financial planner with the Barnum Financial Group in Shelton, CT, where he focuses on his clients’ finances so they can focus on their lives. He teaches consumer-oriented financial planning courses for leading organizations, including Madison Square Garden and Yale New Haven Health Systems. He is a member of Ed Slott’s Elite IRA Advisor Group and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. You can find more articles and videos at michaelwlynch.com. He can be reached at mlynch@barnumfg.com or 203-513-6032.
Securities, investment advisory services, and financial planning services are offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to be complete or to cover every situation, and should not be construed as legal, tax, or accounting advice. Clients should confer with their qualified legal, tax, and accounting advisors as appropriate.
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