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?
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 :)