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Mitchell Kauffman: Reverse Mortgages as a Planning Tool

There are several factors to consider to ensure the best results

Paying the taxes associated with IRA (or other qualified retirement plan) withdrawals is without question the downside of the whole arrangement. But for those who have small or no mortgages on their homes, a “less taxing” approach for generating retirement income has been gaining attention. The strategy, albeit with a cautionary note, involves reducing or delaying IRA withdrawals and replacing that income by tapping the home’s equity using a reverse mortgage.

Mitchell Kauffman
Mitchell Kauffman

Reverse mortgages are in essence mortgage loans that work backwards. Instead of sending a check to the lender every month to pay interest and reduce debt, the mortgagee receives money from the lender and sees a corresponding increase in the mortgage balance. The proceeds can be received in a lump sum, in periodic payments over a period of time or as a credit line that may be used as needed.

The uniqueness and, hence, appeal lies in the fact that no repayment of the loan is required until: 1) the home is sold; 2) when the mortgagee dies; or 3) when the mortgagee has vacated the property for 12 or more months. Depending on the type of reverse mortgage, repayment may be accelerated if the homeowner uses the home as collateral to incur more debt, fails to pay property taxes, fails to insure the home, or fails to insure or maintain the home. The reverse mortgage can be paid off from other sources, or the lender can, in some instances, require the home to be sold to satisfy the reverse mortgage.

The trade-off in this strategy is between creating an ever-growing liability that has no immediate out-of-pocket expenses versus taking money out of the IRA’s tax-free growth environment and paying income tax on the withdrawals.

To illustrate, let’s use a fictional Jim Smith, age 62 and single, as an example. Jim’s traditional IRA has $1 million that grows at 6 percent per year, and his fully paid home has $2 million in equity that appreciates at 5 percent annually. After considering Social Security and pension income, Jim estimates he will need an additional $27,000 to meet his pre-tax retirement spending goal of $80,000 per year.

If Jim simply takes the $27,000 per year from his IRA, at age 70½ the IRA balance would be $1,352,532 and he must begin Required Minimum Distributions (RMD) each year beginning with $49,362. At the time of his death at age 90, his traditional IRA will have a value of about $1,321,556. Jim’s house will have a projected value of $7,840,258, and his gross estate will be about $10,007,102.

Alternatively, if Jim uses an 8 percent reverse mortgage (ignoring origination expenses, which can be high) he will need about $22,950 per year to substitute for the taxable IRA distribution of $27,000 until age 70½. By delaying withdrawals, Jim’s IRA then is worth about $1,640,967. Since his first withdrawal of $59,889 more than meets his income needs, further loans from the reverse mortgage could be stopped.

By the time Jim passes away at 90, and assuming he makes no payments, the balance of the reverse mortgage will have grown to about $1,188,264, and the value of his home would be about $7,840,258. In addition, the projected value of his traditional IRA would be $1,688,655 at age 90. Jim’s gross estate would be about $8,340,648 after the reverse mortgage is paid off.

In essence, by using the reverse mortgage to delay IRA withdrawals, Jim has spent down his estate without incurring the income taxes associated with either selling his home or taking more IRA withdrawals. If his priority is to provide himself a higher cash flow, then by using the reverse mortgage in this manner he has increased it by more than 20 percent. Among the downsides is that his heirs are left with a smaller inheritance and more income taxes. In general, high-wealth clients who are advised to reduce their net worth for estate tax purposes may find a reverse mortgage beneficial. Obviously, these are very general calculations for illustrative purposes only and do not take into account many variables, such as inflation, real estate appreciation and loan costs.

A number of considerations need to be kept in mind. If Jim at age 70½ decided to begin paying back the reverse mortgage with the extra income from his RMD, the mortgage balance at age 90 could be significantly less. Alternatively, he might consider converting his traditional IRA to a Roth IRA and use the reverse mortgage to help cover the associated taxes. Excessive postponement of IRA withdrawals can limit his flexibility when the RMD’s begin and has been called “An Income and Estate Tax Time Bomb.” These issues will be explored in my next article.

The decision to use a reverse mortgage can be complex and may vary for each person’s situation. Some of the factors to consider may include: (1) the homeowner’s desire to leave value to his or her heirs at death, (2) the homeowner’s and the homeowner’s spouse’s age and life expectancy, (3) assumptions regarding future home value appreciation or depreciation, (4) current and future income tax rates, (5) the ever-changing estate tax rates and possible repeal of the estate tax; (6) inflation assumptions, (7) growth of principal and income assumptions over a long period of time, (8) the acceleration terms, conditions and interest rate of the reverse mortgage contract, (9) the changing pension laws, (10) long-term care expenses for the homeowner and the homeowner’s spouse, (11) educational
goals for children and grandchildren, and (12) whether the required minimum distributions will spent or invested during the owner’s lifetime.

Click here for more information on reverse mortgages from the California Department of Real Estate.

In any case, a Retirement Income and Tax Plan that considers the entire picture often provides the best results. Bear in mind that this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant tax or financial planning strategy, contact a financial planner, attorney or tax adviser as appropriate.

— Mitchell Kauffman, CFP®, MSFP, MBA, is the managing principal of Kauffman Wealth Services, 550 Periwinkle Lane in Santa Barbara, and an instructor of financial planning and investment management at UCSB and SBCC. He can be reached at 805.969.5444.

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