If you own your home and have been careful as to how you’ve managed your home equity over the years, you may enter your retirement years with a substantial nest egg to complement your other retirement savings accounts. This article discusses seven ways that you can tap into this equity to enhance your retirement income planning.
A traditional way to access your home equity in retirement is simply to move to a less expensive house. The strategy is straight forward: sell your home for $350,000, replace it with one costing $275,000 and you’ve freed up $75,000. 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 option makes even more sense when you consider the maintenance costs of a large family-home that you may no longer need if your children have moved out.
Retirees choosing to remain in their current homes as they enter retirement can still access their home equity as a source of retirement income. An entire industry has grown up around the “reverse mortgage” concept which allows seniors over age 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.
A company offering to “match” your 401k contribution is in essence offering you “free money” or at least a guaranteed return on investment. Given that over 75% of companies match their employees’ 401k contributions to some extent (the average is $0.50 per $1.00 employee contribution for up to 6% of pay), it is surprising that a large number of workers do not take advantage of this match. By not doing so, you would miss out on both the guaranteed return as well as the time and benefit of the extra compounding effect on your retirement savings growth. Under the right circumstances it may make sense 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.
4.Avoid 401k Loans
A common feature with many 401k plans is the ability to borrow from your vested balance for purposes such as a car purchase, educational expenses, or a home improvement. 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 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 tax-deferred 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.
5.Borrow to Fund IRA Contributions
When a deadline passes for an IRA contribution, the opportunity for that year is lost forever. The foregone compounded impact on retirement savings can be huge. For example, a 35-year old who misses a $3,000 IRA contribution will have $30,000 less in his retirement account at age 65 (assumes an 8% return). It can make both economic and financial sense to use a HELOC loan to finance an IRA contribution – and even more so if the loan can be repaid quickly with an upcoming tax refund. This would be the case if you did not have the money before April 15th to make a contribution, but were expecting a sizable tax refund after that date.
6.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 and options 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 six 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.