It’s been a year full of change for fictional couple Judy and Martin — both scientists at a pharmaceutical company — who first retired in 2019. When COVID-19 emerged, they were suddenly pressed back into service to help with vaccine development.
Now they’re excited to stop working once and for all — with the knowledge that they have saved lives. They will begin taking their required minimum distributions from their retirement accounts, which will be more than sufficient for their living expenses. Knowing that their friends and family are vaccinated, they’ll also take out a home improvement loan to redo their kitchen and start entertaining again. What could be sweeter?
There’s just one vexing issue they wish they could address — taxes. Drawing from their retirement accounts will push them into a higher tax bracket. They would love to identify new deductions that would help to lower their tax liability. Right now, they don’t anticipate exceeding the standard deduction of $25,100, even with the small interest deduction from the new loan.
The Potential Role of a Reverse Mortgage
If this sounds like a situation your clients are facing, you may be surprised that a reverse mortgage, versus a traditional home improvement loan, has the potential to help them not only with their kitchen redo, but with their tax situation.
“You may be surprised that a reverse mortgage, versus a traditional home improvement loan, has the potential to help [clients] not only with their kitchen redo, but with their tax situation.”
”First, some background, and then the possible tax implications: Reverse mortgage loans enable individuals who are 62 or older to convert some of their home equity into income-tax-free money. Home Equity Conversion Mortgage (HECM) reverses empower homeowners to borrow 45%-70% of their home’s value.
These loans can be used for renovations or anything else the borrowers want — from helping adult children with expenses, to the renovations on Judy and Martin’s list. As long as borrowers are able to pay their property taxes, property insurance and regular maintenance costs, they are potentially eligible for reverses.
Borrowers can then repay them on any kind of schedule — or choose to make no payments at all while they are living in their homes. When they move or die, their lender will collect what’s owed after the home is sold.
The Tax Deduction Piece
How can a reverse mortgage help Martin and Judy benefit from more tax deductions?
According to current tax law, married couples can deduct their mortgage interest when they buy a new home, refinance the mortgage for a home purchase, or borrow to finance home improvement. They can only take the deduction during the years that they make interest payments. But even stacked with other deductions, Judy and Martin’s monthly interest payments on a home improvement loan wouldn’t push them over the $25,100+ threshold.
That’s where a reverse mortgage may potentially be helpful. Imagine that Martin and Judy take out a $300,000 reverse mortgage at a variable interest rate of 3.5% (about $10,500 per year). After two years, they pay that interest in one lump sum. Added to their year-two property taxes and dental bills, their deductible expenses suddenly significantly exceed the standard.
Moreover, because the payment was optional, the full amount will be added back into the reverse mortgage line of credit, where it will be available again for withdrawal.
Paying the Taxes on an IRA Rollover
Caroline and Ken (also fictional) illustrate another application for reverses. They are still working and their money has been growing in their IRAs for more than 20 years. They chose traditional, rather than Roth, IRAs on the expectation that when they begin taking distributions, they will be in a lower bracket — lessening the “bite” of the taxes on their IRA funds.
As they approach retirement, their financial advisor is recognizing that their tax bracket may not go down in the following years. For that reason, she is recommending that the couple quickly roll over as much money as possible into Roths — paying their taxes now to benefit from tax-free distributions later.
The dilemma: Where will they find the money to pay those taxes?
If they take it from their current IRA funds, there will be less for the Roths.
Again, a reverse mortgage may be a solution they hadn’t anticipated. They can take money from the reverse to pay the taxes, and keep intact all the funds that they want to roll over.
In short, reverse mortgages have become more than instruments to enable individuals to age in place and enjoy a more comfortable retirement. They may also be a tool for assisting affluent clients with challenges such as reducing taxes.
As life begins to reopen, and clients confront new financial complexities, reverses can help them to achieve their goals in surprisingly creative ways.
Bonny Gilbert, Esq., is with the Bonny Gilbert Reverse Team, Fairway Independent Mortgage Corporation, Boston. This article does not constitute tax and/or financial advice from Fairway.