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Nov 1 2010 12:00AM

Question


I have a traditional Individual Retirement Account (IRA) valued at about $45,000 right now and I own a home that I owe $45,000 on. It is rented for $995 a month. The rate is 5.875 percent fixed and I have seven years left on the loan.

The principal interest taxes and insurance (PITI) payment is $977 month. I was thinking of taking the IRA money and paying off the house. If I do that then I will be able to have a rental income monthly. The IRA has stayed about the same for almost eight years now. With the rental income, I am getting income instead of just having my IRA stay around $45,000.

I figure if I save the rental income, in three and one-half years I can have about what I have now in the IRA. Is this a good idea? I know I will have to pay a 10 percent penalty for early withdrawal as I am only 51 years old. I believe I will also have to pay taxes on the distribution as ordinary income. What should I do?

Answer


FPA member Richard Schuster, J.D., CFP®, managing principal of All Seasons Financial, does not recommend that you implement that plan for several reasons. “First your primary motivation seems to be that your IRA is not growing,” said Schuster. “Certainly everyone experienced a decline during the 2008 market crash, but if your IRA has not grown for eight years it seems that the real issue is your choice of investments.”

“At 51 years old, your investments should be diversified so that you are not only in equities, which based upon your experience I am assuming must be the case,” Schuster said. “But looking at the withdrawal scenario itself, you are correct that upon withdrawing the funds from your IRA you will have additional taxable income of $45,000 but will also incur the 10 percent tax penalty. You do not indicate your tax bracket (and the additional $45,000 of income may put you into a higher income tax bracket) but even assuming an effective federal rate of 20 percent you will lose, with the penalty, more than $10,000. That does not leave you with enough money to pay off the loan. Unless there is flexibility in your loan (usually there isn’t), you will still be paying the same PITI amount although you will of course be paying off the loan faster. When the loan is paid off, you are correct that you will be earning more rental income but remember that income is taxed at ordinary income tax rates so again your anticipated gain is less than you are assuming.”

“Finally, at 51 you may have 15 more years until full retirement age for Social Security and there is real value for you to have an IRA grow on a tax-deferred basis during that time.”

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