The Baby-Boom generation is nearing retirement and it is clear
that millions of aging Boomers are financially under prepared.
Reasons are many - poor savings habits, rising medical costs, the
demise of guaranteed corporate pensions, and the dreaded squeeze
faced by many: i.e. having to pay college costs for their
children, care for their elderly parents, and save for
retirement, all at the same time.
The outlook is not entirely bleak, however. One bright spot that
may help Baby-Boomers achieve secure a retirement is the record
high-level of home ownership and the related growth in home
equity. Home equity, the difference between debt owed on a home
loan and the value of a home, accounts for at least fifty percent
of net wealth for more than half of all U.S. households according
to the Survey of Consumer Finance. In much of the country,
historically low interest rates have spurred refinancings and
kept housing markets strong, both factors in boosting home equity
growth.
Unfortunately, too many homeowners tap into home equity savings
through cash-out refinancings, second-mortgage home equity loans,
or home equity lines of credit (HELOCs) to pay for vacations, new
cars, and other current consumption expenses producing no long-
term wealth appreciation. These homeowners may be seriously
eroding their ability to finance retirement. By cashing out home
equity now, they are spending what has been a vital cushion in
old age for past generations.
Homeowners who manage their home equity prudently, on the other
hand, will enter retirement years with a substantial nest-egg to
complement their other retirement savings accounts. This article
describes seven specific ways in which the home equity nest-egg
can be used to enhance retirement income planning.
1. Downsize - The traditional way to tap home equity in
retirement is simply to move to a less expensive dwelling. The
strategy is straight forward: sell your home for $250,000,
replace it with one costing $150,000 and you've freed up
$100,000. Within IRS guidelines, you can now sell your home and
realize up to $250,000 in tax-free profits if you're single;
$500,000 if married.
This strategy makes even more sense when you consider that
maintenance costs and the headaches of a large family-home are
done away with for the retiree. Yet emotional attachment to a
home is strong and we all know retirees who simply refuse to move
from the home they have lived in for so many years.
2. Reverse Mortgage - Retirees remaining in their homes can still
tap their home equity as a source of retirement income. An entire
industry has grown up around the "reverse mortgage" concept which
allows seniors over 62 to tap into their home's value without
making any repayments during their lifetime. A reverse mortgage
(also known as a HECM - Home Equity Conversion Mortgage) requires
no monthly payment. The payment stream is "reversed": instead of
making monthly payments to a lender, a lender makes payments to
you, typically for the remainder of your life, if you continue to
reside in the home.
Origination fees and closing costs for reverse mortgages are
high. Some people try to avoid these fees by instead borrowing
against their home equity for retirement living expenses with a
regular home equity loan or home equity line of credit (HELOC).
However, this is not always a smart strategy. The reason is that
with either a conventional home equity loan or a HELOC loan, you
will have to make regular monthly payments that may be at a
higher interest rate than can be earned on the loan proceeds
without undue risk. Also, if you use loan proceeds to pay for
routine living expenses, you risk running out of money. A HECM,
on the other hand, can be structured to provides income for the
rest of your life.
There are many pros and cons to reverse mortgages and a complete
discussion is beyond the scope of this article. Suffice it to say
that the reverse mortgage strategy is a sound one for many
retirees. As with any major financial decision, it is essential
that you seek qualified advice before committing to any
particular deal. Federal guidelines, in fact, require reverse
mortgage applicants to participate in counseling sessions prior
to taking out a loan.
3. Purchase Service Years - One of the lesser known facts of
financial life is that many public and some corporate pension
plans allow their employees to purchase additional years of
service credit - sometimes at bargain prices. For example, for an
up front lump-sum payment a teacher with 20 years service might
be eligible to buy 5 additional years and thereby qualify to
retire early.
The cost of buying service years can vary greatly from plan to
plan. A dwindling number of pension plans require only a fixed
dollar payment for each service year purchased regardless of age;
however, most plans now have an actuary compute the cost based
upon the employee's age, income and other variables. In either
case, it is worthwhile to learn about these options. Although up
front costs are steep, you may find that financing the purchase
of service years through a home equity loan or HELOC is a sound
investment. Bear in mind you are looking at the purchase of an
annuity: in exchange for an up front lump-sum payment, you are
promised a steady stream of future payments. As with any major
financial decision, always seek qualified financial advice.
Also, inquire about other non-pension benefits you may qualify
for by purchasing additional service credits. For example, some
employers base retiree health care benefits on the number of
years of service. Purchasing additional service credits may
qualify you for valuable benefits you might not otherwise be
eligible for.
4. Company Match - According to the Investment Company Institute,
75.5% of companies match their employees' 401k plan
contributions. The most common match level is $.50 per $1.00
employee contribution up to the first 6% of pay. Yet despite the
"free money" allure of company matches, a surprisingly large
number of workers do not participate in their companies' 401k
program or do not contribute enough to receive the full employer
match.
Workers electing not to join their employers' 401k plans cite
financial constraints as the primary reason. Yet the long-term
financial impact of non-participation will likely be far more
significant than the short-term discomfort of re-arranging budget
priorities. Not only do non-participants miss an immediate and
guaranteed 50% return on their investment, they also lose time
and the benefit of compounding on their retirement savings
growth.
In the right circumstances it can be a sensible to borrow from a
home equity line of credit (HELOC) to fully fund a 401k. This
strategy involves moving funds from one savings category (home
equity) to another (retirement savings) and makes most sense if:
1) the employer match is significant, 2) HELOC interest rates are
relatively low, 3) the loan can be repaid in a relatively short
period either from higher expected income and/or adjusting budget
priorities and, 4) the participant commits to adjusting
lifestyles and priorities so that future 401k contributions are
made from current income.
Another consideration is whether itemized deductions (including
mortgage interest) fall above the IRS standard deduction amount
($9,700 for couples in 2004). Many long-time homeowners are at
the tail end of their loan amortization meaning that nearly all
of their monthly payments go towards principal. For instance,
during the last five years of a typical 30-year mortgage, only
about 14% of the total payments will be interest payments. This
means little or no tax deduction benefit is being realized - one
of the principal benefits of home ownership. In such cases,
additional home equity borrowing (or refinancing) may result in
tax savings to offset investment risks.
5. Avoid 401k Loans - One popular features of many 401k plans is
the ability to borrow from your vested balance for purposes such
as a car purchase, educational expenses, or a home purchase or
improvements. More than half of all 401k plans offer the loan
option, typically allowing loans up to 50% of the vested account
balance or $50,000, whichever is less.
Many people take out 401k loans believing they are better off
because they will be "pay interest to themselves" rather than a
bank. But the truth is that a 401k loan isn't really a loan at
all; rather, you are spending down your own hard-won retirement
savings. And the interest you pay to yourself won't come close to
replacing the interest lost by not having the funds invested in
retirement account assets.
The bottom line is that 401k loans are almost never a wise
financial move and even less so for homeowners having the option
to borrow against home equity instead. Among other advantages,
interest paid on home equity loans is generally tax-deductible
whereas interest on a 401k loan is not.
6. Borrow to Fund IRA Before April 15 Deadline - Financial
planners generally agree that it is best to either: 1) make
contributions to an IRA as soon as possible (e.g. January 1) to
maximize the power of compounding or, 2) make steady equal
contributions throughout the tax year to gain the benefits of
"income-averaging". Yet many people find themselves up against
the April 15th tax deadline without adequate cash and, so, fail
to make any IRA contribution for that tax year. In some cases,
people miss the opportunity even though they are in line to
receive a substantial tax refund within weeks.
Unfortunately, when the deadline passes, the opportunity to make
an IRA contribution for that year is lost. The foregone
compounded impact on retirement savings can be huge. Consider
that a 35-year old who misses a $3,000 IRA contribution will have
$30,000 (assuming 8% return) less in his retirement account at
age 65. It is sensible, in many situations, to use a HELOC loan
to finance an IRA contribution rather than miss the opportunity
forever. The case for borrowing to fund an IRA is particularly
strong if the loan can be repaid quickly with a tax refund.
7. Take Advantage of IRS "Catch-Up" Rules - Congress created
"catch-up" provisions to give older workers nearing retirement an
additional tool to bolster retirement savings. In a nutshell,
catch-up provisions for the various tax-advantaged retirement
programs (i.e. IRA, 401k, 403b, 457, etc.) permit workers to make
supplemental ("catch-up") contributions starting in the year the
worker turns age 50. The amount of allowable annual catch-up
varies by the type of retirement program and is summarized in
this table.
If, for example, you are 55 and plan to sell your house when you
retire at 62, it may be worthwhile to borrow on your HELOC today
to catch-up on funding your retirement account. HELOCs generally
allow for interest-only payments for several years meaning you
will have to pay relatively low, tax-deductible interest until
the house is sold and you are able to pay the principal balance.
Again, with this strategy, you transfer funds from one savings
category (home equity) to another savings category (tax-
advantaged retirement account) to gain the advantage of higher-
yield retirement account investments compounded for a longer
period.
The strategies outlined in this article certainly do not make
sense for everyone. If you have trouble handling debt or
controlling spending, taking on more debt is absolutely the wrong
thing to do. On the other hand, if you are a financially
responsible person, these seven strategies may help you think
critically about your own situation and about ways the equity in
your home might be used to enhance your retirement income
planning.
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