Q. We are both retired, taking social security and on Medicare. We have a 30-year mortgage at 5 percent with monthly principal and interest payments of $1,950. We now owe $94,000 and have five years until it is paid off. It would really help our cash flow if we could pay this off. We are in a pretty low tax bracket and we are considering taking money from either an IRA or an after tax annuity to pay this off. The annuity is worth less than what we put in so there would be no taxes owed but we would have a 5 percent surrender charge on anything we withdraw above 10 percent (which would not be enough to make a dent in the mortgage). The surrender charges don’t go away until three more years. We know we’d owe taxes on the IRA withdrawal but we are leaning toward using this since we would not have any surrender charges. From which pot of money would you advise we take to pay off our mortgage?
A. I definitely would not take a large lump sum from your IRA to pay off your mortgage or for any other reason unless it was a true emergency. You will owe federal taxes on any amount withdrawn as well as state taxes if your state has an income tax. In North Carolina you’d owe at least 7 percent in addition to the federal tax. If you take a distribution of $94,000, most, if not all, of that amount will be taxed at the 25 percent or higher federal income tax rate. In North Carolina, your combined federal and state tax rate would be 32 percent meaning you will owe income tax of $30,080 on your withdrawal. If you had to take more from your IRA to come up with the money for taxes you are just compounding the problem. A larger distribution will only result in more taxes and where do you get the money to pay those taxes?
It doesn’t end there. Depending on your other income, a large withdrawal from your IRA could cause you to pay a higher premium amount for Medicare Part B and Medicare prescription drug coverage. These plans pay for doctor services, outpatient care, prescription drugs and other medical services. The government used to pay a major portion of the costs for these plans but as part of the health reform law, if you have higher income in any one year the law requires an adjustment to your monthly Medicare part B and Medicare prescription drug coverage premiums. The most recent Federal tax return is used to determine if you pay a higher premium. If you file married, filing jointly and your modified adjusted gross income (MAGI) is greater than $170,000, or if a different filing status and MAGI is greater than $85,000 you will pay higher premiums. The additional amount you will owe above the base premium ($99.90/month for Part B and $0 for prescription drug coverage in 2012) is based on your MAGI and can range in an additional charge of $40.00 to $219.80 per month for Part B and 11.60 to $66.40 for Prescription drug coverage. The MAGI threshold was adjusted for inflation but is now frozen until after year 2019. If you increase your MAGI by taking a $94,000 distribution from your IRA you may see your premiums rise somewhere between a total of $619.20 and $3,434.40 next year.
Based on your interest rate and only five more years to pay off your mortgage, the interest you would be save by eliminating your mortgage now is around $13,000. Not worth the tax bite of a distribution from your IRA. It might be worth the surrender charge of $4,700 if you take the money from your annuity. I suggest you take the annual 10 percent surrender free withdrawal from your annuity to help with cash flow each year. As the surrender charge diminishes the portion of interest on your mortgage payment will also be diminishing. I’d wait until the surrender charge is zero and then evaluate what other conservative investment options are available for this money before using it to pay any remaining mortgage balance.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 99466, Raleigh, NC 27624