Dear Liz: My wife and I are in our mid-40s and planning to buy what likely will be the last house we’ll purchase. I’ve decided to withdraw around $15,000 from my IRA to buy down the rate, which will guarantee returns in the form of interest savings, even if those will be less than the returns I would earn if I left the money in the account. My real question is about our current house. We owe around $77,000 on a house that could likely fetch in the low $200,000 range. I’ve looked at it up, down and sideways. Would it make more sense to rent, sell, or rent then sell after a couple of years to avoid the capital gains tax?
Answer: Sometimes it can make sense to buy down a mortgage interest rate by paying more upfront if you plan to stay in the home for many years. The deals vary by lender, but you might pay 1% of the loan amount (one point) to get a rate that’s 0.25% lower, or 2% (two points) to get the rate reduced by 0.5%. For example, paying two points on a $200,000 mortgage, or $4,000, could lower the rate from 4.5% to 4%. You would drop the monthly payment about $59, and it would take you nearly six years for the slightly lower monthly payments to offset what you paid upfront.
You complicate the math, though, when the money used to buy down the rate comes out of a retirement account. That money is taxed as income and would likely be penalized as well because you aren’t yet 59½. (There’s an exception to the penalty for first-time home buyers who withdraw up to $10,000, but they’ll still owe income tax on the withdrawal.) The tax bill varies according to your tax bracket and your state, but you can expect it to equal roughly one-quarter to one-half of the amount withdrawn.
In addition to the tax bill, you’ve also given up future tax-deferred returns on the money. And because most people’s incomes drop in retirement, you’re probably paying a higher tax rate than you would if you withdrew the money later.
A good rule of thumb is to consult a tax pro before you take any money out of a retirement account. The rules can be complex and it’s easy to make an expensive mistake. A tax pro also could advise you about the tax implications of renting vs. selling, although you might also want to talk to anyone you know who’s a landlord about what’s involved with renting out a property.
The simplest solution may be to sell your current home and use the equity to reduce the size of the loan you’ll need on the next residence, rather than raiding a retirement fund to get a slightly lower rate.
Survivor benefits and earnings tests
Dear Liz: In a recent column, you suggested someone might not want to apply for early survivor benefits if they were still working because earnings over $18,240 will be reduced by $1 for every $2 earned. I don’t understand the logic. One can still earn $18,240, plus half of additional earnings plus the survivor benefit. Why do you recommend it is better to not apply?
Answer: You’ve misunderstood how the earnings test works.
When you apply for Social Security benefits before your own full retirement age and continue to work, your benefit — not your pay — is reduced by $1 for every $2 you earn over a certain limit, which in 2020 is $18,240.
Let’s say your survivor benefit is $1,000 a month, or $12,000 a year. If you earn $32,240 a year, that’s $14,000 over the earnings test limit. Your $12,000 benefit would be reduced by $7,000 — half of $14,000. You’d get $5,000 a year or $416.67 a month.
Now let’s say you earn $42,240, or $24,000 over the limit. Half of $24,000 is $12,000. Your $12,000 benefit is completely offset by the earnings test, reducing your check to zero.
The earnings test disappears at full retirement age, which is somewhere between 66 and 67, depending on when you were born. After that point, your earnings no longer impact your benefit amount.
Liz Weston, Certified Financial Planner, is a personal finance columnist for NerdWallet. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.