How To Pay Off Your Mortgage Using Pre-Tax Money

Retirement funds are useful for supporting us in old age, by providing an income in addition to Social Security. But they also can be tapped before you leave the work force. The idea is to use this money for something that benefits you economically over the long term. Like getting rid of your home mortgage, which drains you over the decades with interest charges. Telling us how to do this is Stephen Nelson, the president of Birchwood Capital in North County San Diego.

Larry Light: Is there a way to use retirement funds, like an IRA, funds to pay off the bank without having to take a taxable distribution? This money, of course, is invested before taxes, and only is taxed when it’s withdrawn.

Stephen Nelson: No, unfortunately. But with a little tax planning and a strategy utilizing Roth conversions, you can save yourself a huge tax bill and pay off your home. Now, does this avoid taxes altogether? It certainly does not. There are no free lunches. But it may reduce the taxes you’d pay by up to 50%.

Light: What can you tell me about the Roth conversion strategy?

Nelson: This is a process that deliberately moves money from a pre-tax account, like a 401(k) or a traditional IRA, to an after-tax account. The benefit being that any distributions and any growth on that money is henceforth tax-free. So you can do anything with the money that you wish, like using it to pay off your mortgage.

The trick is managing the tax liability, since any amount withdrawn from a pre-tax account will be taxed at ordinary income rates. But the good news is that this is one piece that is under your control.

Light: OK, show me some examples of how this would play out.

Nelson: I’ll lay out two examples to show you the power of the Roth conversion strategy to pay off your mortgage. One shows the wrong way to do it, one shows the right way. For the sake of simplicity, let’s assume zero current taxable income and a joint tax return.

Light: Hit us with the wrong way.

Nelson: You do everything at once. Say you converted $1 million from pre-tax money to after-tax money. You would pay approximately $300,000 in federal taxes. Ouch! The conversion throws you from the lowest tax bracket up into the highest tax bracket, which is 37%. So, every marginal dollar you withdraw gets taxed at the maximum rate. You would net $700,000 that could be used to pay off your mortgage.

Light: But the other method gets you even more money, as there’s less of a tax hit, right?

Nelson: Right. You stretch out the withdrawals over time. In our second scenario, if you spread the Roth conversions over five years, performing a $200,000 conversion each year, you’d lower your tax bracket from 37% to 24%. This cuts your effective rate basically in half.

The net result is having $847,500 available for a mortgage payoff or 21% more money as compared to the first example. Due to our progressive tax system, money is first converted at the lowest rates possible. The more you can fill up the lower tax brackets without spilling into higher brackets each year, the more taxes you will save.

Light: If a couple was wanting to pay off their mortgage as they entered retirement this looks like an excellent strategy to help them not get killed in taxes.

Nelson: Precisely. The strategy can be tailored to fit someone’s exact situation. With a little bit of planning, you can save yourself hundreds of thousands of dollars and pay off your mortgage within a few years.