Two Financial Scenarios in Retirement

The conventional wisdom is that the best way to a financially secure retirement is to contribute as much as possible to a 401(k) plan.   This Kiplinger article, reveals that many financial advisors are okay with their clients keeping a mortgage in retirement and often prioritize catch-up for 401(k) contributions over paying off the mortgage.  This Investopedia articlefocuses on the overall level of retirement saving instead of factors like the existence of Roth assets and liquid assets, or the absence of debt.

The analysis in this post shows that many factors in addition to net worth and total liquid financial assets impact financial security of retired households. The analysis centers around a comparison of the financial situation of two households depicted in the table below.  Both households are married couples at age 62 with identical work histories and identical potential Social Security benefits.

The key financial statistics for the first household are:

·      Net worth $2,640,000,

·      Total liquid financial assets $1,600,000,

·      Liquid assets in a conventional retirement account $1,600,000,

·      Roth assets $20,000,

·      Series E and Series I U.S bonds $20,000,

·      Outstanding mortgage $200,000

·      Annual mortgage payments $32,805

·      Years left on mortgage 7

The key financial statistics for the second household are:

·      Net worth $2,025,000,

·      Total liquid financial assets $825,000.

·      Liquid financial assets in a retirement account $700,000,

·      Roth assets $75,000,

·      Series E and Series I bonds $50,000,

·      Outstanding mortgage $0,

·      Annual Mortgage payment NA,

·      Years left on mortgage NA

Household one, with its higher levels of financial assets and net worth, is not necessarily better prepared for retirement than household two with no debt and greater levels of Roth and non-retirement assets.

First, the household with a mortgage will have to spend more than the household without a mortgage in retirement to cover both the mortgage and additional consumption.  This higher level of spending will persist until the outstanding mortgage balance is totally paid off.  Moreover, the mandatory mortgage payment reduces the ability of the household to prevent depletion of assets during a market downturn.

Second, the household with most funds in a conventional retirement plan will have a higher tax obligation than a household with Roth assets and liquid non-retirement assets for several reasons. All disbursements from the conventional retirement plan are taxed as ordinary income.  By contrast, the disbursements from the Roth IRA are untaxed after age 59 ½. The Roth disbursements will also reduce the portion of Social Security benefits subject to federal and state income tax because the disbursements are not included in adjusted gross income. Similarly, the use of liquid non-retirement financial assets instead of conventional retirement assets reduces AGI and taxes because a share of the non-retirement liquid assets has already been taxed.

The potential advantages of living without a mortgage can be illustrated by comparing the amount of funds available for consumption after taxes and mortgage payments for the two households.  An empirical analysis would also consider tax burdens in retirement for both households.

Two scenarios are considered.

The first scenario assumes that neither household claims Social Security.  Both households spend 4 percent of liquid financial assets, all of which comes from the conventional retirement account.  Household two (the household without a mortgage and with a lower reliance on conventional retirement assets) fares better than household one even though household one has a net worth that is over 30 percent higher than the net worth of household two.

Key Results Scenario One:

·      The amount available for consumption after the mortgage and taxes is $3,789 or 13 percent higher for household two than household one.  This savings occurs every year.

·      The differential in tax payments (household two minus household one) is $3,584 per year.

The second scenario assumes that both households claim Social Security.  Both households spend 4 percent of liquid financial assets with the amount distributed from each account (conventional retirement, Roth, and liquid financial assets) proportional to the account balance.  The disbursement scenarios are consistent with the larger tax saving from the use of Roth and liquid financial assets once the households claim Social Security benefits.  Also, I assumed that half of the disbursement from the government bonds is fully taxable interest and half, the original investment, is not taxed. 

Key Results Scenario Two: 

·      Available for consumption after taxes and mortgage payments is $59,127 for household two compared to $53,972 for household one.

·      Taxes paid are $1,873 for household two compared to $6,823 for household one.

Concluding Remarks:  Both of the households depicted here will likely claim Social Security either immediately or shortly after retirement if they remain in their current home.  Both households could achieve a more financially secure retirement by downsizing and using the funds to delay claiming Social Security and converting traditional retirement assets to Roth assets.  The incentive to downsize is especially pronounced for the household with the large 401(k) and the outstanding mortgage.  (See this previous post.)   Go here for a discussion of reasons why people early in retirement should convert  traditional retirement assets to Roth assets.  Note the successful implementation of this strategy requires the existence of some liquid funds outside of a retirement account to fund current consumption in retirement.