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