Max out Roth IRA or pay off mortgage?


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Dear Dr. Don,
My husband and I are 41 years old. We could pay off our mortgage in three years if we pay an additional amount toward the principal each month. We have $60,000 in a traditional individual retirement account, but are not adding to the IRA.

Do you think we should put the extra money toward a Roth IRA, which we could max out, or pay off our mortgage first? Then, in three years, we could put more toward the Roth IRA. By then, we’d have the money that would otherwise be used for the additional principal payments as well as the base mortgage payments.

Thank you!
— Nancy Nicety

Dear Nancy,
I’m wondering when the loan would be paid off if you didn’t make the additional principal payments. My guess is six years.

So, the question is whether six years from now, would you rather have the house paid off for three years and have just three years to fully fund your IRA accounts? Or, would you prefer to have the house paid off with six years of payments to fully funding your IRA accounts? I’d choose the latter, while recognizing you’ve freed up more than just the IRA funding when you paid off your mortgage early.

My guidance is that you should prepay your mortgage when you expect to earn less after tax on your investments than the effective (after-tax) interest rate on your mortgage. I don’t know the interest rate on your loan, based on what you’ve written here.

In general, the more conservative you are in investing, the more likely it is that additional principal payments make sense. The U.S. stock market, as measured by the Standard & Poor’s 500 index, gained more than 30 percent in 2013. While past returns don’t indicate future performance, investing would have provided you with a better return compared with additional principal payments in 2013.

If you’re so close to paying off your mortgage, you don’t have much mortgage interest expense. Why is that important? The mortgage interest deduction probably isn’t cutting your income taxes by much.

I’m sure you are aware that Roth IRA contributions are made with after-tax dollars. When withdrawn from the account as qualified distributions, they are tax-free. Since you aren’t old enough to qualify for catch-up contributions, the IRA contribution limits are $5,500. Roth IRA contributions are limited based on your modified adjusted gross income and filing status.

If an extra $11,000 annually in additional principal payments for the next three years allows you to pay off your mortgage, that’s great. Here’s what I think you’re missing: You can’t make up those contributions once the mortgage is paid off. That’s other than the $2,000 a year in catch-up contributions after age 50. You’ve got enough money in your household budget now to make the mortgage payments and pay down the loan balance by $11,000 a year. That means you don’t need to free up the mortgage payment sooner to max out the Roth IRA contributions.

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