You have a mortgage, but you also have enough money to pay it off. Should you?
Many federal employees, as they approach retirement, have paid off all their debt except for their mortgage. They have saved diligently through the Thrift Savings Plan and they have a good-sized nest egg. It seems to be a match made in heaven. You have this debt and you have enough money to pay it off, so shouldn’t you? It’s a question I hear all the time from feds and I can see why.
The short answer: Probably not. But the long answer is worth considering.
First: Are you at least 59½? If you aren’t, any withdrawals may be subject to a 10% penalty as well as taxes. Sometimes this penalty is waived if you have already retired but I would do thorough research beforehand to make sure you are in the clear.
The Big One: Taxes
For most feds, most of their TSP savings is on the traditional side and not the Roth. This means that when you put the money in, you didn’t have to pay taxes on that money, but you do when you take it out. If you do have money in the Roth TSP, any qualified distribution will come out completely tax free.
One misconception that I see is that some feds assume that traditional TSP distributions will be taxed at capital gains tax rates, but this is not the case. These distributions are simply added to your income in whatever year you take the money out.
It is also important to note that the TSP is required to withhold 20% of any traditional TSP distributions to cover taxes so you may have to take out more than initially thought. This doesn’t mean that you’ll owe exactly 20% of your distribution in taxes. It could be more or less than that.
Let’s do a quick example to see how this would work.
Let’s say a couple is over 59½ and their joint income comes to about 80K. They owe $250,000 on their house and they have $500,000 in the traditional TSP. They decide that they want to be completely debt free and pay off their mortgage with their TSP.
They request a withdrawal of $250,000, and the TSP sends them $200,000. The remaining $50,000 gets sent directly to the IRS. Now that they know about the 20% withholding, they request an additional $62,500 so that they get $50,000 after the withholding.
They ended up having to take out a total of $312,500 from their TSP, which is a big bill just to get rid of a monthly mortgage payment of $1,500-$1,800.
But this is where it gets sticky. That $312,500 would then be added to their income of 80,000 for a total of $392,500. To keep the tax calculations simple, let’s assume that the only deduction they have is the standard deduction for a couple, which is $24,800 in 2020. Their taxable income would be $367,700 ($392,500 minus the $24,800 deduction).
Before withdrawing the money from the TSP, with an income of only 80k, they were in the 12% tax bracket. Now they are slammed up into the 32% marginal tax bracket with an effective tax rate of around 20%. That means they would have to pay almost $75,000 in income taxes this year!
Now this cost would be slightly lessened by the fact that they would save money in interest over the rest of their would-be mortgage term. But even if they saved $100,000 in interest over the course of the 15-20 years that they would have had a payment, it costs them $75,000 of cold hard cash right now.
Opportunity Cost: The Second Kicker
Now if the numbers already didn’t look bad enough, the opportunity cost of the money taken out of the TSP is sure to be the final straw. If this couple kept the $312,500 in their TSP and invested it 100% in the G fund for 15 years, assuming an annual return of 2.23% (the 10-year average for the G fund), that $312,500 would have turned into $435,036.24. Now imagine if they had invested a portion of that money in some of the other funds which, historically, have earned much more than 2.23%. The difference becomes unignorable.
I am not saying that it never makes sense to pay off your mortgage early with your TSP. Sometimes it does. Just make sure you understand the long-term ramifications. Everyone’s situation is different, but it is your responsibility to know what this type of decision means for you and your family.
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