Having just filed our 2012 taxes, I’m pondering an interesting question. Over the past year I set aside $5,000 that I’d planned to put into a traditional IRA as a nondeductible (after-tax) contribution. It occurs to me that I could instead use the money as a principal prepayment on our mortgage. The question is: Should I?
[The IRA contribution is nondeductible because I participated in my company’s 401(k) plan in 2012. As a result I am not eligible to deduct my IRA contributions from our federal taxes. As the IRS explains: “If you were covered by a retirement plan (qualified pension, profit-sharing (including 401(k)), annuity, SEP, SIMPLE, etc.) at work or through self-employment, your IRA deduction may be reduced or eliminated. But you can still make contributions to an IRA even if you cannot deduct them.”]
If every year I chose $5,000 mortgage prepayments over nondeductible IRA contributions, then:
Advantages:
- Faster payoff. We would pay off the mortgage in 20 years (or fewer) instead of 30.
- Less interest. We would save at least $75,000 in interest payments over the life of the loan.
- Zero risk. Each prepayment would yield a guaranteed return of 3.625%/year (our mortgage rate) through 2042.
- More equity. We would have more equity in the house if we decide to sell (if we move or “trade up”) or if we need to do a cash-out refinance.
Disadvantages:
- Underfunding retirement? We would be reducing our retirement savings. (However, during years 21-30 we could pay ourselves “mortgage payments” directly into our retirement savings. If we are disciplined about it, those payments would make up much of the difference.)
- Tax deferral. The prepayment wouldn’t experience tax-deferred growth as it would in an IRA.
- Lower returns? There’s the chance that an IRA would grow in value significantly more than 3.625%/year. Additionally, the IRA would continue to grow (or shrink) in value until withdrawn (or until we die, I suppose), whereas a prepayment’s “zero-risk return” ends when the 30-year mortgage term ends.
- Inflation hedge. If the dollar experiences high inflation in the next few years, we’d be better off if we were carrying lots of debt (i.e., a high mortgage balance).
Either way I wouldn’t be putting all of our retirement eggs into one basket, in that I’m already making contributions to a 401(k) retirement plan. (By the way, the best answer I’ve found to how much should I save for retirement? is in Rande Spiegelman’s article “Play the Percentages”.)
Two things made me start thinking about this trade-off between mortgages and nondeductable IRAs:
- the notion that both are illiquid ways to invest for retirement, and
- this Mortgage Professor article about mortgage repayment as a long-term investment.
The Professor addresses a similar question in his article Roth IRA contributions vs. mortgage prepayment. (My question is about traditional IRAs.) The only other relevant advice I’ve found so far is in this paper comparing mortgage prepayment with pre-tax retirement contributions. (My question is about nondeductible traditional IRAs.)
Until this year my strategy for retirement investing has been:
- If you have a 401(k) (or similar) plan with company matching contributions, first make contributions up to the company match. (For example, if your company matches up to $3,000 of contributions then put your first $3,000 into the 401(k).)
- Next, make contributions to a Roth IRA up to the maximum allowable amount.
- Next, max out your pre-tax contributions to the 401(k).
- Next, make deductible contributions to a traditional IRA up to the maximum allowable amount.
- Next, make nondeductible contributions to a traditional IRA up to the maximum allowable amount.
So the conundrum is whether I should replace step 5 (or even step 4) with “Next, make prepayments against your mortgage principal.” Arguably I have until April 15 to decide, although if I choose prepayment then every month’s delay costs me $500 more in interest paid over the life of the loan.