Double Trouble

Jonathan Clements

PEOPLE OFTEN ACT foolishly and then desperately try to justify their financial sins. A case in point: Those who take on too much debt, can’t get it paid off by retirement—and end up servicing huge mortgages and other loans long after their paychecks have come to an end.

Cue the tap dancing. The indebted start waxing eloquent about the virtues of the mortgage-interest tax deduction and how it’s smart to pay the bank 4% while they invest the borrowed money at 10%. As of 2016, 70.1% of households headed by someone age 65 to 74 were carrying debt, up from 51.4% in 1998, according to the Federal Reserve’s just released Survey of Consumer Finances.

Unfortunately, lenders and financial advisors have no incentive to counter such foolishness, because lenders want to make loans and financial advisors don’t want clients selling off big chunks of their portfolio to pay down debt.

But foolish it is. For every $1 of mortgage interest paid, our retirees might save just 25 cents in federal income taxes. This assumes they’re in the 25% marginal tax bracket and they itemize their deductions. What if they take the standard deduction instead? That $1 of mortgage interest is costing them the full $1.

Moreover, it’s extraordinarily unlikely that our retirees will earn 10%. Indeed, if their portfolio is split evenly between stocks and bonds, their stocks might notch 6%, but the bonds will be hard-pressed to clock 3%. Earning an uncertain 3% on half your money, while paying a fixed 4% on your mortgage, doesn’t seem so smart.

That brings us to another, less-publicized problem: Even if retirees can afford the mortgage and other loan payments, they could incur some hefty unexpected expenses. How so? It’s all about the size of your retirement living costs—and how you pay for them.

A popular rule of thumb says that, to retire in comfort, you need retirement income equal to 80% of your final salary. At first blush, that makes sense: Once you quit the workforce, you’re no longer socking away 10% or so of your income for retirement, no longer coughing up an employee’s 7.65% Social Security and Medicare payroll tax, and no longer paying for commuting costs and office clothes.

But many retirees discover they can retire comfortably on just 50% or 60% of their preretirement income. Why? Partly, it’s because folks often save far more than 10% in their final years in the workforce, as they make a last push to get their finances in shape. But partly, it’s because many people get their mortgage paid off before they retire, and that sharply reduces their living costs.

What if you don’t get the mortgage paid off? You’ll need more retirement income. That might mean drawing more heavily on your retirement accounts and paying income taxes. Alternatively, it could mean selling winning stocks positions in your taxable account and triggering capital gains taxes.

Either way, the extra taxes are unfortunate. But the tax bite doesn’t end there. As a result of this additional income, you might find that up to 85% of your Social Security retirement benefit is also taxed. This double tax whammy is sometimes referred to as the “tax torpedo.”

The tax on Social Security benefits kicks in at relatively low income levels, so it’s tough to avoid entirely, even if you don’t have debts to repay. Still, the extra income needed to service debt can make the tax on benefits especially punishing. An example: Say you’re married, your only income is annual IRA withdrawals of $55,000 and you’re in the 15% federal income tax bracket. If you also pull in $20,000 in Social Security benefits, 85% of that benefit will be taxable, costing you $2,550 in extra taxes. What if you needed to withdraw $15,000 less from your IRA each year, because you had no debts to service? Just 55.5% of your Social Security benefit would be taxable and you’d have to turn over just $1,665 in extra taxes, or $885 less.

It gets worse. The extra income needed to service debt can lead to higher Medicare premiums. In 2017, the standard Medicare Part B premium is $134 a month. But for single individuals with incomes above $85,000 and couples above $170,000, the premiums are higher—sometimes as much as $294.60 per month higher. On top of that, high income households may have to pay as much as $76.20 per month extra for Medicare’s prescription drug benefit.

These extra premiums are based on your income tax return from two years earlier. What counts is your so-called modified adjusted gross income, which includes interest from municipal bonds. The bottom line: If your income is high enough, you could find yourself paying an additional $4,450 a year in Medicare premiums. Want to cut that tab? A good first step is getting all debt paid off by retirement.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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