Part of the American Dream is paying off a mortgage and other debt before retirement. But we know that more Americans are carrying debt into retirement.
According to a Transamerica Center for Retirement Studies survey:
- 28% of Retirees had mortgage debt
- 45% of Retirees had non-mortgage debt
But because of the ideals surrounding a debt-free retirement, some pre-retirees may consider taking additional measures to pay off the debt right before they retire.
They may think “What if I go ahead and take Social Security, withdraw from my investments and just get rid of this debt?”
And this may seem like a great idea. They might free up thousands of dollars in monthly payments by paying off the debt.
But doing this has the potential for long term consequences that we need to help them consider.
Let’s take a look at someone who decides to continue working but also take Social Security and distributions from an IRA to pay off their debt.
Here are a some potential problems:
- The client will receive lower Social Security for life than if they had waited until retirement to claim.
- This may cause additional Medicare premiums in the future.
- It may put them in unnecessarily high Federal and State marginal tax brackets.
- Social Security benefits may be reduced while they work and claim before Full Retirement Age.
- It may cause Social Security benefits to become taxable.
Unfortunately, there is not a simple rule of thumb here because each client situation will be different.
- They may have very high interest rates on some debt.
- They may be at an income level where this actually makes sense.
- They may have a job loss or reduced income that is creating a negative cash flow situation.
- It may make sense if we have higher tax rates in the future.
I would bet that the majority of time you run into this situation, though, it is not going to be a valid reason to take Social Security early and withdraw from an IRA creating taxes. So we have to show clients the long term consequences of these actions.
So, instead of arguing with your client or prospect about why this is a bad idea, I suggest you simply run some scenarios. First, show them how paying off the debt early will affect them in the long term. Then, show them how strategically paying off the debt over time will affect them.
Ultimately it makes since to let the client decided for themselves after seeing the side by side comparison. Now to sum this up we all would like to have a debt free retirement, but need to discuss with clients how it will affect them over the long run. While you may not be able to convince every client what is in their best interest, at least they will know what the long term effects are to a decision like this.
Corey is SSN’s in-house consultant on tax planning. He shows advisors how to dig into complex strategies and consider the implications of taxes as clients are getting ready to retire.