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I have $10,000 extra cash that I can either use to pay down my 5% mortgage, or contribute to my IRA. I'm 30 years old. I hope to pay off the mortgage in about 5 years.

I'm stymied, because:

  • Paying $10,000 into my mortgage earns me $500 a year (in interest savings) for the life of the mortgage -- hopefully 5 years.
  • Paying $10,000 into my IRA earns me roughly a $3000 lowering of my tax bill now (plus CD ROI of about 1% at retirement time.)

So I can get $2500 ($500 a year over 5 years), after which I will have paid my mortgage off with other money; or I could get $3000 in cash right now plus a bit of extra money when I retire.

Even ignoring the future benefits of the IRA contribution, it feels like I should put the money into my IRA: it's an immediate 30% return on investment, as opposed to a 5% return for 5 years. But if I always make that decision, I won't be paying off my mortgage early, and that $500 will stretch out over 30 years, costing me $15,000!

Which actually leaves me with more money in the end? What basic principle of math am I missing?

Update:

The principle of math I was missing is that, assuming I'm taxed at the same rate when I retire as I am taxed now, I end up with exactly as much money as if I had invested the $10k and not received a $3k tax reduction. (Of course, my income level and tax laws will have changed by then, but let's ignore that.)

So the question simplifies to, "Should I put $10k toward eliminating a 5% debt or toward a 1% investment?" in which case I should clearly put it toward the mortgage.

I was confused by the government incentive into thinking that retirement investment was a sweeter deal than it actually is. This is probably their goal, and probably a noble one :)

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1  
How old are you, when do you plan to retire? –  MrChrister Mar 28 '11 at 23:17
    
The $3000 off your tax bill can become significant depending on what you do with it. If you apply that toward your mortgage then you could have $10k in the IRA and $3k in the mortgage. –  Stainsor Apr 20 '11 at 15:19

5 Answers 5

up vote 5 down vote accepted

If it's either/or, I'd pay down the mortgage, no question.

I know I'm in the minority, but I'm not a fan of tax-advantaged retirement accounts. There are too many things that can change between now and the next 30 years (the time frame that you'll be able to withdraw from your IRA account without penalty). The rules governing these accounts can change at any time, and I don't think they'll be changes for the better.

Putting the money toward your mortgage will relieve you of that monthly payment faster. The benefits of IRAs come retirement age are too uncertain for my taste.

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I'll join your minority. I treat IRAs/401k as safety cushion. If nothing else works at least i'll have something (maybe). –  Vitalik Mar 29 '11 at 4:39
    
I'm with mbhunter on the retirement accounts. Not to say that they don't have a place in a balanced portfolio, but they shouldn't be your sole retirement income. I'm planning for retirement on a mix of RRSPs (Canadian IRAs), TFSA (Similar to a Roth IRA -paid with after tax dollars, but earnings are not income) and a healthy dose of non-sheltered investments paid for with after tax dollars.. –  Chris Cudmore Mar 29 '11 at 13:31

It depends on the relative rates and relative risk. Ignore the deduction. You want to compare the rates of the investment and the mortgage, either both after-tax or both before-tax.

Your mortgage costs you 5% (a bit less after-tax), and prepayments effectively yield a guaranteed 5% return. If you can earn more than that in your IRA with a risk-free investment, invest. If you can earn more than that in your IRA while taking on a degree of risk that you are comfortable with, invest. If not, pay down your mortgage.

See this article: Mortgage Prepayment as Investment:

For example, the borrower with a 6% mortgage who has excess cash flow would do well to use it to pay down the mortgage balance if the alternative is investment in assets that yield 2%. But if two years down the road the same assets yield 7%, the borrower can stop allocating excess cash flow to the mortgage and start accumulating financial assets.

Note that he's not comparing the relative risk of the investments. Paying down your mortgage has a guaranteed return. You're talking about CDs, which are low risk, so your comparison is simple. If your alternative investment is stocks, then there's an element of risk that it won't earn enough to outpace the mortgage cost.

Update: hopefully this example makes it clearer:

For example, lets compare investing $100,000 in repayment of a 6% mortgage with investing it in a fund that pays 5% before-tax, and taxes are deferred for 10 years. For the mortgage, we enter 10 years for the period, 3.6% (if that is the applicable rate) for the after tax return, $100,000 as the present value, and we obtain a future value of $142,429. For the alternative investment, we do the same except we enter 5% as the return, and we get a future value of $162,889. However, taxes are now due on the $62,889 of interest, which reduces the future value to $137,734. The mortgage repayment does a little better.

So if your marginal tax rate is 30%, you have $10k extra cash to do something with right now, mortgage rate is 5%, IRA CD APY is 1%, and assuming retirement in 30 years:

  • Prepay is worth: $28,067.94
  • IRA is worth: $13,478.49 but only $9,434.94 after taxes (30%) are paid when you make a withdrawal.

If you want to plug it into a spreadsheet, the formula to use is (substitute your own values):

=FV(<rate>, <years>, 0, -<cash amount>, 1)

(Note the minus sign before the cash amount.) Make sure you use after tax rates for both so that you're comparing apples to apples. Then multiply your IRA amount by (1-taxrate) to get the value after you pay future taxes on IRA withdrawals.

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+1 because you added risk to your discussion. You need to compare guaranteed 5% against an equivalent guaranteed return. If Risk didn't matter, you should go play roulette: it pays 35-to-1. –  Alex B Mar 29 '11 at 18:43
    
I've clarified my original post: I should not ignore the reduction in taxes, because it's like a $3000 check being handed to me on April 15th. And I've intentionally not talked about risk to keep the question simple. I do understand the theory that a mortgage at N% is good debt if you can use your money on a guaranteed >N% investment; my question here is, why does infinitely delaying my mortgage seem like the right choice when the choice is made year-by-year? –  user3146 Mar 30 '11 at 15:36
    
You're comparing pre-tax rates with after-tax rates. If you're in the 30% bracket, your effective mortgage interest rate is 3.5%. If you think of the $10k into your IRA as providing you with a $3k check on tax day, you need to think about the interest on your mortgage the same way. Another article from the same site that may be helpful: How Do Taxes Figure in the Loan Repayment Decision? –  bstpierre Mar 30 '11 at 16:04
    
Infinitely delaying your mortgage seems like the right choice because you're projecting current assumptions into the future. If those assumptions change two years from now, your decision will be different. –  bstpierre Mar 30 '11 at 16:05

Personally, I would split the difference, putting about half into each. Simply because it balances out the problem and I don't have to fret about whether one or the other will provide a significant difference. As bstpierre points out, the one which will make you more in the end is the one which you can grow the fastest. The mortgage payment is locked at 5% growth, which, while modest, is also essentially guaranteed at this point. The CD in your IRA is likely less than that amount, even after tax consideration.

A couple additional points to consider:

  1. Are you referring to a $3000 deduction, or a delta of $3000 on your taxes? Most deductions will adjust your taxable income, but you don't get the full amount back. For example, if you land in the 25% bracket, a $3000 deduction will get you about $750 removed from your taxes (or added to your refund). The amount you can deduct for IRA contributions is also limited by income bracket, make sure you've done the paperwork to determine the actual effect this will have.
  2. Have you considered a Roth IRA? You don't get the tax deduction now, but (assuming laws governing Roth distributions don't change), you won't get taxed on the money when you take it out during retirement. If you're not planning to withdraw it for another 30 years, this might be more cost effective in the long run (depending on future growth and your current tax bracket).
  3. IRAs have an annual contribution limit of $5000. You will be penalized for any amount in excess of that which you contribute this year. You can take advantage of the situation by contributing $5000 for last year (assuming you haven't yet) before the deadline (April 15th this year IIRC), and another $5000 to count as this year's contribution, but keep in mind that another similar windfall you would not be allowed to contribute this year.
  4. Paying off the mortgage sooner will free up a large portion of your cash flow, which you can then focus on putting into your IRA, 401k, or even a regular savings account. Or just for spending on toys or vacations.
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I would also consider the following factors:

  • Stability of Income
  • Liquid non-indexed reserves.
  • Total Debt (all loans including mortgage)
  • Debt:Earnings ratio
  • Expected Retirement income.

How stable is your income? Are you in an industry that could vanish in the near future? How long would it take you to replace this income? If you are at risk, then you need to consider that your lenders do not care how fast you've paid down your debt. All the care about is that you make next month's payment. You need to have liquid reserves available to weather any storm. (current wisdom is 3-6 months expenses). It may be prudent to put this money in GICs or T-bills. There may be an early withdrawal penalty, but at least you won't lose your house. (obviously, this isn't as important when you can actually retire all debt)

What's your debt level? If it's more than 3x income, then reducing that number might be the most prudent.

On another note, what is your expected retirement income? IRAs defer the tax to a later year. BUT, if you expect a great pension, it is feasible that you might be in a higher tax bracket on retirement (when you withdraw the funds) than you are now -- A situation that makes Indexed Retirement planning counterproductive. (Rich people don't buy IRAs)

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Rich People do get Roth IRAs. Tax-free in retirement! (typically they can use the loophole to convert in order to get around the income limitations) –  NPFinance Mar 29 '11 at 18:52

If its deductible, the IRA is a no-brainer. You're netting a positive return just from the tax deduction, and you'll have years of tax-free appreciation.

You're already on track to pay off your mortgage in 5 years, the impact of $10,000 on the balance now is not very consequential. On the other hand, you won't have an opportunity to make additional IRA contributions.

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