You think having a mortgage is smart and having a retirement account is also smart? Sometimes, no.

A reader nearing retirement wrote in to ask if he should dip into his IRA to pay off a mortgage. The short answer to his question: yes.

The long answer: The right move depends on a lot of things, including age and future tax rates, but for many people over 60 a mortgage paydown makes sense.

Much confusion surrounds the arithmetic of tax-deferred accounts like IRAs and 401(k)s. Say you have $100,000 in an IRA and you’re in the 35% tax bracket. You figure that having to pay $35,000 in tax is a big reason not to take the money out any sooner than you have to.

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This is a fallacy. That $35,000 already belongs to the tax collector. You are only the custodian of this sum. You possess a mere $65,000. Postponing the withdrawal doesn’t give you a chance to put the tax collector’s assets to work for you. On the contrary, you are working for the government when you invest that part of the money.

If your efforts double the $100,000 account to $200,000, then you have made $65,000 for yourself and $35,000 for the government. When you withdraw the $200,000, only $130,000 belongs to you. The other $70,000 is handed over.

What, then, is the point of tax-deferred savings, if not to get an interest-free loan from the government? The availability of retirement accounts has a quite different tax effect. The tax benefit consists in making investment profits (on your piece of the pie) tax-exempt.

Here’s how that math works. If your investing causes the account to double, and you pay the 35% tax on the way out, your $65,000 doubles to $130,000. If there were no such things as IRAs and 401(k)s, your $65,000 would grow to something less than $130,000 because taxes would nibble away at your investment profits.

The tax exemption helps, but it’s not to die for. Bear in mind that taxable yields on both stocks and bonds are tiny nowadays, and that both dividends and capital gains get favorable rates on federal tax returns.

Contrast this arrangement with the tax deferral that big investors like Donald Trump get via such means as accelerated depreciation on business assets. If they postpone a $35,000 tax bill, they invest that money for their own benefit. When they pay the $35,000 back in a later tax return, they don’t owe earnings on that money to the IRS. They get to keep the earnings.

In short, IRAs are nice, but they are small potatoes compared to the tax dodges of business owners.

Once you put aside the notion that withdrawals from an IRA are bad because you have to pay tax on them, you can think of the mortgage-versus-IRA puzzle in a different way. The correct way to analyze the situation is to compare the aftertax cost of the mortgage with the aftertax return on a safe investment inside the IRA.

If you have a 3% mortgage, chances are your aftertax cost is close to 3%. Why? Because most people don’t itemize any more, or if they do itemize, don’t get very far past the $24,800 starting point set by the standard deduction (on joint returns). In olden days, when interest rates were higher and the standard deduction lower, the ability to deduct mortgage interest reduced the effective cost of borrowing by several percentage points. Now the deduction doesn’t do much good.

As for the return on money inside the IRA: You have to compare what you’re paying on a mortgage with what you could earn on something with comparable risk. Since the mortgage is a guaranteed obligation (you can’t welch on it), the earning asset to look at is one that is guaranteed, namely a U.S. Treasury obligation. Treasuries pay around 1% these days.

Now for taxes on that Treasury: As explained above, the IRA gives you an exemption from tax on investment returns. So your 1% pretax return becomes 1% aftertax. Whoopee.

There you have it. Your mortgage has you borrowing money at 3% aftertax, or perhaps 2% if you are a rare taxpayer able to get full mileage out of a mortgage interest deduction. This debt enables you to earn 1% aftertax in your IRA. This is a losing proposition.

Don’t make the mistake of assuming you can invest the IRA in stocks and earn a lot more than 1%. You might, but this is a risky venture, and there are better ways to gamble on the stock market than to take out what is in effect a margin loan from your mortgage lender. You could more cheaply do the gamble by using options and futures.

So, if you are nearing retirement with a mortgage over your head, think about eliminating the debt by cashing in retirement money.

Four caveats:

1. Preserve liquidity. You need to have funds you can get at in an emergency. If all you’ve got for that purpose is the IRA, don’t pay off the mortgage.

2. Consider future tax rates. The example above assumes a constant tax bracket. If your bracket is destined to go down, the arithmetic changes, and it doesn’t make sense to cash in the IRA.

You might see lower taxes down the road—if, for example, you will be moving from New York City to Fort Lauderdale. But it’s a mistake to assume that tax brackets always go down in retirement. They can get pushed up by Medicare premium surcharges and by mandatory IRA withdrawals. They will be pushed up as states cope with the Covid recession and with the cost of lavish pensions for their employees.

3. Don’t pay the penalty. You owe a 10% federal penalty on retirement withdrawals before age 59½. Wait until you’re past that point.

4. Preserve IRA flexibility. That means keeping enough in the tax-deferred account to take advantage of a strategic withdrawal when your tax bracket is temporarily reduced, for example by extraordinary medical costs or by a gap year between retirement and starting Social Security.

Originally published at Forbes

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