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Ask Dr. Don

Ask Dr. Don

Today, Dr. Don explains how to take an early IRA distribution and whether to prepay a mortgage.

Early IRA distribution

Dr. Don,
I took $9,000 out of my IRA to pay off a pool loan, which was financed with a second mortgage on our home, in order to clear our home for sale. The lender wouldn't let us sell the home without paying off the pool first. Please tell me how much I can expect to pay in taxes on the $9,000 I took. We did not pay anything yet as far as penalties for early withdrawal, etc.
Pool Paine

Dear Paine,
Home equity loans aren't portable because they are backed by the value of the property. You must have been upside down on the house, at least after real estate commissions, or you would have been able to pay the loan off from the sale proceeds.

The taxes due on the distribution will be based on your marginal federal income tax rate. Last year's rate would be a good estimate of this year's rate. On top of the income tax, you will pay a 10 percent penalty for the early distribution. The penalty will be part of the calculation of your 2000 income taxes. If the IRA was invested in a certificate of deposit, you may have to pay an early withdrawal penalty to the bank. Your IRA provider is required to withhold 20 percent of the distribution (mandatory withholding) for the payment of federal income tax, and already sent that money to the federal government on your behalf.

 

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Prepay mortgage

Dr. Don,
I have a 15-year mortgage with a 6.375 percent interest rate and a $130,000 balance. I recently sold enough stock to repay the loan but am unsure if it's a good decision to retire the loan rather than reinvest the money. The monthly payment is $1,650. I recently retired but my wife still works and making the $1,650 payment is not a problem. I have no other debts and still have $600,000 invested in the stock market. Should I pay off the mortgage and invest the $1,650 monthly?
Prepay Pilling

Dear Prepay,
Whether it makes sense to prepay your mortgage depends on your tax rate, your attitude toward risk and what you expect to earn on the money if you invest it.

You've got a great mortgage rate. If you get to use the interest deduction on your taxes, it brings the after-tax cost even lower. If you're in the 30 percent bracket, your after-tax cost of debt is about 4.5 percent. To be better off investing, you need to earn more than 4.5 percent after-tax. You can do that risk-free with the two-year Treasury note or a 2-1/2 year CD. Stocks don't have a guaranteed return, but can be expected to return more than the T-note or the CD over a longer term holding period.

Since you've already sold the stock, you've incurred any tax burden from the sale of those shares. Deferring the capital gains tax on the stock sales would have been another reason not to pre-pay the mortgage.

At its core you're asking should you invest $130,000 today, or $1,650 over the balance of the loan. I estimate that there's about 8.5 years remaining on your mortgage. Let's assume that all investment returns come in the form of capital gains taxed at 20 percent, and that the taxes aren't due until we sell the portfolios. We'll also assume that the investment in stocks earns 12 percent annually.

The lump sum would be worth $341,188 before tax and $298,950 after tax. The monthly investment would be worth $290,265 before tax and $265,871 after-tax. The income tax savings, invested to the end of the mortgage, would provide an estimated $15,750 after-tax. So under this scenario, you would be $48,829 better off by not prepaying your mortgage. But remember: There aren't any guarantees on the portfolio's return when you invest in stocks.

Related information:
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Bankrate.com writers base their answers on our editorial content and advice of financial professionals. We make no claims or representations about the accuracy, timeliness or completeness of such content, advice or the answers provided to you. Our content, advice and answers are intended only to assist you with your financial decisions. However, by its nature such information is broad in scope. Your financial situation is unique, and our content, advice and answers may not be appropriate for your situation. Accordingly, we recommend that you get different opinions and seek the advice of your accountant and other financial advisers before making any final decisions or implementing any financial or investment strategy.

-- Posted: June 5, 2000

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