Cash or Mortgage

Financial Planning Tax Strategies
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I’m just trying to get a sanity check here. I apologize if it is unclear.

I’m single, retired, a whole heap in my IRA and ROTH, already took my RMD for the year in January. I own my house, but have many years left on my mortgage. Between SS, pensions and the RMD I only have a bit of headroom before exceeding the 24% federal tax bracket.

It expect to be buying another house where my daughter and her family will live. I could pay cash several times over, and my credit is good, so I do not doubt I would qualify for a mortgage.

Paying cash, rather than getting a mortgage, would almost entirely mean the withdrawal from the IRA would fall in the 35% tax bracket. That is 11% more than what withdrawals to cover mortgage payments would be taxed at. But mortgage interest is every year, at what I can expect to be 6% or higher. So, in two or three years, the incremental mortgage interest would exceed the extra 11% up front taxes from paying cash that came out of the IRA.

Having gotten that far, I realized I’d failed to take into account my state income taxes, which would be close to 7%. Just as I didn’t take into account deducting the mortgage interest… or can I, for a house I don’t live in? I don’t intend to charge rent, so that complication is avoided.

What am I missing? Is this all nonsense?

(FWIW, the interest rate on the mortgage on my residence is 2.75%, and I am in no rush to pay that off.)

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The rate of return on the amount of the capital in the IRA.

If the cost of the house is $500K (to make up a number), you’re right to consider the costs of the one-time tax hit on your withdrawal from the IRA (11%) vs. the incremental cost of taking out a mortgage on the capital (6% per year or so). But the other major impact is that if you leave the $500K in your IRA and take out the mortgage, you’ll be earning a return on the $500K in the IRA and whatever the appreciation/depreciation is on the house (the mortgage acts as leverage here). If you pay cash, you lose the return on the $500K in the IRA.

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Yes, I certainly didn’t consider that. Thanks!

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One other thing you that may be worth factoring into decisions – what will happen to your estate when you die? You have an IRA. Who is the beneficiary? Will those dollars create issues for beneficiary? (I see people here who are concerned about taxes on inherited IRAs. Keep in mind Congress can change those tax considerations any time they wish.

We have a simple situation - our estate will divided amoung five charitable organizations. That eliminates some considerations from our portfolio management decisions.

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The bulk of my estate goes to the daughter who will be using the house. In effect what I pay for the house comes out of her inheritance. That includes most of the IRA, and that ten-year rule will hit her hard. At least it will if there is as much as I hope will be in the account.

But you have me thinking of another factor. If I died today, one tenth of my IRA would put her in a high tax bracket every year. Not that I expect to be gone soon, but I need to think about that too.

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Every situation is different. We find SS and RMDs exceed our needs and wants. Unless something like the 70s style Stagflation or another lost decade happens our estate value will likely grow at about half the rate of the S&P.

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No you don’t. Being in a higher tax bracket is the good kind of problem, and anyway, you’ll be dead.

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I can’t argue with that! :sunglasses:

I can, however, try to do the best I can for those getting the remains of my assets, in particular my daughter.

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FWIW, this seems like a bit of an easy choice to me.

The really important factor appears to be the massive early payment of taxes you have to endure if you pull out the full price of the house from your IRA. If the house is $500K (made-up number) with a $400K mortgage, you’d have to pull $600K from your IRA to net the $400K for the mortgage. That’s $200K that evaporates in the form of a tax payment.

You’d have to pull about $37K per year from your IRA to cover the mortgage payment going forward (assuming that 6% rate and 35% taxes on the withdrawal). So that’s the annual cost you avoid by pulling the money out and paying cash. But if you left the $600K in the IRA, you’d likely earn something close to that at a minimum - you can get north of 4% on CD’s today.

The kicker for me is that you always have the ability to change your mind, barring anything weird in the mortgage, if you decide to take the loan instead of pay cash - because you can decide down the road to just pull the funds from the IRA and pay off the mortgage at any time. But you can’t do the reverse (I don’t think? Not tax advice).

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Have you asked daughter what she prefers?

Asking for a friend.
:slightly_smiling_face:
ralph

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11

Sorry to be late to the discussion. I was on a trip to the Oregon Coast and not paying attention to TMF.

I didn’t see anyone answer this question for you…

In general, for purchase mortgages taken out after 2017 (TCJA), mortgage interest on a total of up to a principal limit of $750k in mortgages on your first and second homes can be deducted. The catch is - interest on the oldest mortgage is counted first. So if your 2.75% mortgage balance is, say, $400k, then you would only be able to deduct interest on up to $350k in principal for the new mortgage, even if the mortgage on the new home is $500k. The rules get rather complex because for a while, the limit was $1MM and if one of your two homes was acquired prior to Oct 31, 1987, then any mortgage on it may be grandfathered in. IRS Pub 936 (Home Mortgage Interest Deduction) 2024 Publication 936 Table 1 will help you calculate the amount of deductible interest.

AJ

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Pulling the money from the IRA now (or maybe part this year and part next year, if she can wait that long for a house) will give her a tax break when she inherits the house, and will avoid higher taxes on the inherited IRA.

So even though you will pay a big chunk in taxes now, the future tax benefits may exceed the hit you will take now.

AJ

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You don’t say what percent of your IRA money is in the Roth vs a regular IRA. This mtters and gives you flexibility in controlling taxable income.

Also, you could consider getting a mortgage on a 5 or 10 years term rather than 30. You’ll get a lower interest rate.

Mike

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As has been said, every situation is different. I am 83 and my spouse in 72. There is a good basis for expecting my wife to exceed 100 years of age at her death. We have no children or siblings one might reasonably expect to be alive in 20 years. My wife is a former CFO - so not unfamiliar with the subject.

Our joint stock brokerage account 30.2%; My wife’s Roth IRA 9.4%; My IRA 8.8% and a Wasmer managed bond account 11.2%.

Taking the entire portfolio together we have: 40.5% Large Cap stock; 25.6% Domestic bonds, 18.6% International stock and 3.3% cash or equivalents.

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Roughly 75% IRA, 25% ROTH. But the split to the daughter is more like 2/3, 1/3

Good to know, but shouldn’t be an issue.

Can you please elaborate on this part? tax break when she inherits the house. My current house is in a trust, and (I have not yet talked with my attorney) my assumption is that the new house would be in the trust too. The trust goes entirely to my daughter.

Briefly, the IRA and ROTH have designations to various family members, with a large portion going to that daughter. The trust, with the house(s) goes to the daughter, as does “the rest” (car and other stuff, bank accounts) that goes through probate.

Thanks to everyone who has contributed here. It is much appreciated.

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She will get a step up in value for both houses upon your death, so there will be no capital gains taxes on any capital gains that occurred during your lifetime. If she sells either house shortly after your death, she may actually be able to take a slight capital loss because of selling costs on the sale.

Then, presuming she chooses to live in one of the houses, for the house that she lives in, once she’s both owned it and lived in it for at least 2 years, she will be able to take advantage of the $250k/$500k capital gains exemption for homeowners, so she may not have to pay any capital gains taxes when she sells. And even if she has to pay some capital gains taxes, at least under current law, capital gains rates are generally lower than ordinary income rates.

So most, if not all, of the equity in both houses can be sheltered from taxes. If you have a mortgage on either house, that decreases the amount of equity that is sheltered.

On the other hand, if she inherits your traditional IRA, she will have to fully disburse the account within 10 years of your death, and pay ordinary income tax amounts on the withdrawals. If you are concerned about the amount of the disbursements pushing her into a high tax bracket, but don’t want to push yourself into a high tax bracket by withdrawing enough money to pay for the house initially, then you may want to structure something like this:

Buy her a house using a mortgage with at least 20% down (so you avoid PMI), taking enough money for the down payment out of your Traditional IRA to push yourself to the top of the 22% or the 24% bracket. Each year after that, take out enough money out of your Traditional IRA to push you to the top of the same bracket and use the money to pay down the principal on the mortgage. Do this until the mortgage on her house is paid off. Then decide if you would rather use the same technique to do Roth conversions or to pay down your 2.75% mortgage.

That way, you won’t push yourself above the 22% or 24% bracket, the houses will still get a very large amount of equity protected by the step up, and she won’t have to pay so much in taxes on the T-IRA disbursements.

I will note that all of this presumes the current tax law remains in place.

AJ

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17

Great stuff, AJ. Thanks!

Yes, if she inherits soon those ten years will be taxed heavily. Along with ten years of ROTH, there will be a lot she has to learn to invest. (Of course I hope to last a good while longer, but one never knows.)

Before RMD kicked in this year, whatever headroom I had before going past the 24% bracket was used up by a rollover to ROTH each December. My first RMD is this year, more than I needed last year, and pushing me close to the top of 24%. So minimal rollover this year, unless I choose to do some rollover at 32%.

Clearly my situation is not one to complain about.

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It refeshing that you mention your good fortune. To me it seems people are more interested in getting more (i.e. paying less tax) than appreciating how lucky and fortunate they are to have such problems.

Today there is a roofing crew replacing our hail damaged roof - 10 or 12 guys who appear Latino. I expect my roof replacement would be more expensive if some of the folks in DC had their dreams come true.

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19

I will point out that the OBBA did add $750 to the standard deduction for single filers. So the top of the 24% bracket in 2025 for a single filer over 65 would be:

Taxable income limit for 24%: $197,300
Standard deduction: $ 15,750
Additional deduction over 65: $ 2,000

Total of $215,050

(Unfortunately, your income would be too high to take advantage of the extra $6,000 exemption for seniors that the OBBA provides.)

So, presuming an RMD of $200k (which is in the ballpark of the top of the 24% bracket) at 73, that means that your IRA is currently north of $5MM. If you presume an average 8% gain going forward, that means that your IRA will probably continue to grow until you are 90. As you point out, $500k+ (1/10 of the current balance) of taxable ordinary income is going to put your daughter into at least the 35% bracket - possibly higher if she has other income and also depending on her filing status. So you paying some taxes at 32%, either for the house or for Roth conversions, is probably going to decrease the total tax bill that you and she will pay on that IRA.

AJ

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Wouldn’t it be SS+pensions+RMD = ~$200k for that bracket edge?

Does that exemption have a cliff eligibility, or does it phase out?