Using a reverse mortgage in retirement as a strategic planning tool

[TheHappyPhilosopher]

This is an idea I really have not thought about until I listened to this podcast (which incidentally I was interviewed on last year) about reverse mortgages. I  have always thought these to be horrible predatory products designed to steal houses from orphans and widows but I am reconsidering my bias. Seems like this can be a great planning strategy for the mass affluent.

http://physicianfinancialsuccess.com/harlan-accola-on-reverse-mortgages-for-the-wealthy/

It is a really interesting idea and would like to know what others think. Maybe WCI could dig into this and write an article someday.

General idea is that many people have a lot of home equity tied up in their primary residence, especially if they are at traditional retirement age. In fact, the FHA program mentioned is not available to anyone younger then 62 (sorry PoF). Instead of taking money out of an IRA which will be taxed as income, you take out home equity in one of three ways (lump sum, periodic payments, line of credit) and leave the IRA money to keep growing until you are forced to take RMD's. You pay interest on the home equity loans, but they are tax free. It would take analysis to see if it was worth it. When you pay back the loan you get to take a deduction for the interest which can be used to offset other taxable income.

Also the line of credit will grow each month at some rate according to a formula. The loan is non recourse which means even if the value of the house crashes the losses are absorbed by the program (federal). There were some pretty cool estate planning things addressed as well in this long but extremely boring article.

http://retirementincomeresearch.com/wp-content/uploads/2016/05/Journal-of-Taxation_Recovering-a-Lost-Deduction__Barry-Sacks.pdf

The real benefit that stuck out to me aside from tax and estate planning was that this could be used to reduce sequence of return risk the first 5-8 years of retirement. Essentially you strip out home equity in a down market. Even if you never take any money out, having a line of credit that cannot be taken away and keeps growing seems like an amazing hedge against sequencing and longevity risk.

Biggest downside is that there is an upfront cost to setting one up. I can't really see any other negative. What am I missing here?

[Sneezy]

I agree these have gotten a bad rap in the past

Many people who take them out don't understand how they work and are then surprised (or their family is) when the equity is depleted and not passed on when the borrower die (or even worse when children/others living in the house have to more out).  You may or may not consider these downsides or just necessary features

The mortgage professor site has lots of info on these https://www.mtgprofessor.com/reverse_mortgages.htm

I see the potential for a reverse mortgage line of credit to provide some buffer for those who retire with barely enough to cover yearly expenses.  Also a good way to use you home equity without moving although many would be better off downsizing to access that equity directly.

Finally, if you open a line of credit early it will grow at the rate of the loan (probably faster than the rate of inflation) so you might end up with a LOC worth more than the home http://www.forbes.com/sites/wadepfau/2016/03/01/how-does-the-line-of-credit-for-a-reverse-mortgage-work/#1d221d0736ca

Since the bank is limited to taking back the house, one could potentially take a reverse mortgage at 62, let it grow until 90 or so and then cash it out, sticking the bank with the difference between the $$$ and the value of the house.  You can decide if you think that is ethical or not.  Of course, the initial equity is limited to around 625K and many docs will have homes with significantly higher values

[jfoxcpacfp]

I agree. They've changed a log since 2013 but the public hasn't caught up to the facts yet. Blog post I wrote a few months ago, Why I've Learned to Respect Reverse Mortgages.

[jhwkr542]

Agree with everything so far. At my age though (31), I'd be hesitant to rely on them in retirement because if they can change for the better (like recently), they can always change for the worse. Certainly an option though for people who could use some equity that didn't save enough and are now currently retired or near retirement.

[jfoxcpacfp]

jhwkr542 wrote:

Agree with everything so far. At my age though (31), I’d be hesitant to rely on them in retirement because if they can change for the better (like recently), they can always change for the worse. Certainly an option though for people who could use some equity that didn’t save enough and are now currently retired or near retirement.

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They are not a conversation I would engage in with someone your age. For someone nearing or in retirement, however, who has a lot of "dead" equity in a house who hasn't planned ahead for a market drop (i.e. doesn't have a financial plan in place) and needs to fund living expenses, they can present a nice choice. This article in InvestmentNews has a pretty good overview.

[TheHappyPhilosopher]

jfoxcpacfp wrote:

jhwkr542 wrote:

Agree with everything so far. At my age though (31), I’d be hesitant to rely on them in retirement because if they can change for the better (like recently), they can always change for the worse. Certainly an option though for people who could use some equity that didn’t save enough and are now currently retired or near retirement.

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They are not a conversation I would engage in with someone your age. For someone nearing or in retirement, however, who has a lot of “dead” equity in a house who hasn’t planned ahead for a market drop (i.e. doesn’t have a financial plan in place) and needs to fund living expenses, they can present a nice choice. This article in InvestmentNews has a pretty good overview.

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Yeah I think they should not even be on a persons radar until the qualifying age of 62. My feeling is that the laws will be changed. This seems like one of those too good to be true products like the backdoor Roth IRA (Which will probably be eliminated one of these years). Seems like the intent was to help people with very little savings in retirement, but I think the people that can really benefit the most are high net worth individuals with a lot of home equity.

[Craigy]

TheHappyPhilosopher wrote:

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Yeah I think they should not even be on a persons radar until the qualifying age of 62. My feeling is that the laws will be changed. This seems like one of those too good to be true products like the backdoor Roth IRA (Which will probably be eliminated one of these years). Seems like the intent was to help people with very little savings in retirement, but I think the people that can really benefit the most are high net worth individuals with a lot of home equity.

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Just like in grade school, the people who earn the extra points already have the A.

[Zaphod]

I dont think this particular version will be around when most of us can utilize the feature, its just too good to be true and surely an unintended or thought to not be used aspect of it.

[The White Coat Investor]

So, that fear of loss is such a big issue and the truth is that we always have to give up something to get something. There is no question that you will lose some equity if you do a reverse mortgage, no different than if you drew money from your 401(k) or your IRA. You’re going to lose some money out of there, but the fact is that with a reverse mortgage, while you give up something, you gain more. While you’re losing equity in your left pocket, you’re gaining cash and other assets in your right pocket.

The second myth is that this is just something we don’t need. We’ve got plenty of money. We don’t need it. We’re doing fine. What would we get a reverse mortgage for when we already paid it off and we don’t need one? It is true that there is a lot of things we don’t need, but it doesn’t mean that we don’t want them in order to make our life better, make our retirement better, make an inheritance to our children and the legacy that we pass on better. Most of the listeners to your podcast have no need for a reverse mortgage. Of course, we don’t need a car either but it’s awfully nice to have. We don’t need a cellphone, but it’s nice to have. That’s really the second thing that we run into with people. I don’t need one. Well, once you understand what’s there, you’re going to want one is the explanation that we usually have.

The third myth is that these are really expensive and there is no question that closing costs and the interest rates are a little bit higher on a reverse mortgage than they are on a forward mortgage, but the fact is this is just that anything that’s good is more expensive. I didn’t go around when I needed some medical attention. I didn’t go around and look for the cheapest doctor or travel to another country to find somebody that would do the procedure for less money. I wanted quality and that’s the same thing that you’re going to run into in any field, and so this costs more because it’s worth more. But there is a lot of factors that go into that.

Okay, so far so good. Those are the traditional beefs with it, all of which I agree with. I don't want to give away an asset, I don't need a reverse mortgage, and they are really expensive. Let's see how he does against them:

Well, the first thing is that any income that comes from reverse mortgage is tax free, so that will automatically send off all kinds of bells for financial advisors and for your clients. Because anything that’s tax free for people that are wealthy and have assets is a really important issue, especially when you go into retirement. More people die going down Mount Everest than climbing Mount Everest. Retirement is full of, as you very aptly mention often, any financial situation is such the landmine.

All loans are tax-free. Not impressed with this argument. I don't borrow against my car, my stocks, or my life insurance for "tax-free income," so why would I do it against my house? And do the people who use this analogy ever climb anything? Of course everyone dies on the way down. When things get really bad (weather has moved in, you're sick, your partner is nuts, your crampon is broken, it's dark, you're out of oxygen etc.) do you say, "Ah, what the heck? I'm going to the summit! Of course not. You start down. Then you die. Besides, you don't fall up. You fall down. So if you die in a fall, you're on your way down. Stupid analogy.

Somebody says we’ll I’ve got $3 million. Well, not really. You only have $2 million because you’ve got at least a million dollars you’ve got to pay in taxes that as soon as you draw that money out. Tax free equity that comes from your home between 50 and 75 percent depending upon your age is the number one fact that we want to get out.

You have an effective tax rate in retirement of 33%? That is a seriously wealthy person. Think about how large your IRA has to be for your RMD to get you to an effective tax rate of 33%.  It's got to be at least a $10 Million IRA. What does it take to get that? Well, you need to put $150K a year into tax-deferred accounts for 30 years and earn 5% on it. When I talk about the fact that I have $189K in tax-deferred space available to me, you all tell me I'm as rare as a unicorn. The fact that he uses this example suggests to me a lack of understanding of the tax code or of math, neither of which gives me much confidence in his conclusions.

It’s not a good idea and trying to create equity in retirement and not eliminate your monthly mortgage payment is a big mistake when you look at the facts

Those facts rely only on a mathematical model and ignore both behavior and risk. We all know that mathematically, on paper, the best thing to do is to maximally leverage yourself for your entire life. Why don't we do that? Behavior and risk.

The order that it is, depending upon people’s wealth, it goes back and forth between taxes and housing. If someone has a net worth of $1 million or under, the biggest single expense in their retirement is going to be housing. If they have a net worth of $1 million or more, generally their biggest expense is going to be taxes. But always number 1 or number 2 is going to be housing,

WTH? If you have a net worth of just $1 Million, you're paying almost nothing in taxes. Let's assume $400K is in your home and $600K is in a portfolio. Let's say $500K of it is in a tax-deferred account. The RMD on a $500K IRA? That's $20K. Your first $20K is tax-free if you're married with the standard deduction. Give me a break. And housing? If your house is paid off what is the likelihood that your housing is going to cost you more than healthcare or food? It doesn't pass the sniff test. The best way to reduce your housing costs is to pay off your house, not take out a reverse mortgage. Bizarre argument.

You need to understand, Isaac, that while we’re giving money to our financial advisor and we’re filling up bucket 2, our nest egg, by earning more money in bucket 1 than what we’re spending, that we’re going to have a nice little nest egg when it comes to retirement.

I guess I'm less likely to take financial advice from someone who feels he needs a financial advisor. That's just me though.

“Did you know your children didn’t want [your home equity]? They’ll take the money certainly. They’ll sell your house and take the money, but that’s not the most efficient way to pass it on.

Say what? Your kids get a step-up in basis at death. So home equity passes tax-free. That's an extremely efficient way to pass money. All they gotta do is wait 90 days for the realtor to sell it. Is that such a big deal or so inefficient? I think not.

Emotionally, you don’t want to take money out of [home equity. Logically, you should always take money out of [home equity] first rather than let it sit there like it’s in a glass case in your living room something to look at and not use.

This is a straw man argument. Anyone who thinks your home equity is "just sitting there not doing anything" doesn't understand how this works. What your home equity is doing is # 1 paying you dividends in the form of saved rent and # 2 increasing at about the rate of inflation. That's a pretty darn good investment.

If I plan to be in a 25-percent to 30-percent tax bracket or some higher elevated tax bracket especially if you live in some place like California where you got a massive state tax on top of it, now I’m not pulling money out of my retirement account, paying taxes and then paying a mortgage payment.

Another odd argument. What do you mean you're not pulling money out of your retirement account. Either the retirement account is tax-free (i.e. a Roth IRA) and no RMDs are required, or you HAVE to pull money out of your retirement account and pay taxes on it. If you're going to take it out and pay the taxes on it, you might as well spend it.

The closing costs on this loan were roughly $20,000, very insignificant. It will mostly be saved in taxes within the first couple of years. While in the more expensive tool, yes, it is. but he didn’t have to write a check for the $20,000.

Now we're talking about expenses finally. I guess if $20K is an insignificant fee for you, then sure, by all means, take out a loan you don't need. But this sleight of hand that you don't have to write a check is just that. It's like folding in your closing costs when you refinance a loan. Not only are you paying those costs, but you're essentially financing them over decades!

Now I don't know if I'm for or against a reverse mortgage and in what situations I could possibly support using one. But I remain unconvinced by this interview that the typical physician ought to be using one. Readers won't be surprised to learn Mr. Accola makes his living, at least in part, from selling reverse mortgages. Now Wade Pfau seems to think they may have a place, but I didn't find his writings particularly convincing either, especially since he came out with them about the same time he started writing about how useful whole life insurance once and it was revealed that his research was sponsored by an insurance company. Perhaps the reverse mortgage industry sponsored his research about reverse mortgages, I don't know.

It's probably worth looking into and researching, but there's a lot of salesmanship and hype going on here. Reminds me a lot of the cash value insurance industry. Caveat Emptor!

[TheHappyPhilosopher]

The White Coat Investor wrote:

Now I don’t know if I’m for or against a reverse mortgage and in what situations I could possibly support using one. But I remain unconvinced by this interview that the typical physician ought to be using one. Readers won’t be surprised to learn Mr. Accola makes his living, at least in part, from selling reverse mortgages. Now Wade Pfau seems to think they may have a place, but I didn’t find his writings particularly convincing either, especially since he came out with them about the same time he started writing about how useful whole life insurance once and it was revealed that his research was sponsored by an insurance company. Perhaps the reverse mortgage industry sponsored his research about reverse mortgages, I don’t know.

It’s probably worth looking into and researching, but there’s a lot of salesmanship and hype going on here. Reminds me a lot of the cash value insurance industry. Caveat Emptor!

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Exactly, that is why I asked the question. I wanted you to answer this for me. Separate the hype from facts. You are the WCI

Seriously though, I am looking for people who have analyzed this from a non-biased perspective. Obviously a salesman is not the best pace for information, but I posted the link because that was my entry point into the subject. It is admittedly very sales y.

The best way I can think of to potentially use this product is to establish a line of credit at age 62 if you are at or above a 4% swr (No one reading this blog of course because they are too rich at age 62) as a potential hedge against a bad sequence of returns your first several years of retirement (and potentially to control your taxable income in there is something that will negatively effect you like going out of the 0% cap gains). I also want to see an cost/benefit analysis from a tax standpoint for a 'typical' doc in retirement. I could not really find anything like this out there which is why I posed the question.

Come on, someone besides Pfau must have analyzed this thing.

[The White Coat Investor]

I suspect there are better ways to decrease sequence of returns risk. A SPIA immediately comes to mind. I'll try to look into them enough to do a post about them.

[RocDoc]

Happy Philosopher, thanks for presenting this podcast on reverse mortgages. It was intriguing reading about it and trying to figure out if it really could save money due to tax efficiency. Despite, WCI's pretty awesome shakedown, I still find the concept interesting. I'm going to get my husband to help me do some excel spread sheets like POF does to look into it more.

Thanks also to WCI. I enjoyed reading your critique and evaluation. Great analysis that took some wind out of the whole idea. I'm still going to try to do some excel spread sheets before I give up though.

I think Hatton1 had some wise advice in a previous forum section, that you can only minimize taxes so far. I guess that is unless you're Trump!

[Hatton]

Thanks to WCI for posting the transcript of the podcast.  I just could not make myself listen to it.  I look forward to RocDocs excel post.  I am leery of this concept as well.  Yes unless you have HUGE carry forward losses it is hard to see staying in a bracket that pays 0% tax on cap gains and dividends.  Demuths idea involves huge capital gain taxes so I am not interested. Tax laws constantly change so it is best not to fall in love with one strategy but constantly reassess and correct.

[TheHappyPhilosopher]

hatton1 wrote:

Thanks to WCI for posting the transcript of the podcast.  I just could not make myself listen to it.  I look forward to RocDocs excel post.  I am leery of this concept as well.  Yes unless you have HUGE carry forward losses it is hard to see staying in a bracket that pays 0% tax on cap gains and dividends.  Demuths idea involves huge capital gain taxes so I am not interested. Tax laws constantly change so it is best not to fall in love with one strategy but constantly reassess and correct.

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Actually I think it's quite easy to stay in the 0% cap gains bracket, it's like 75k for a married couple. The things that would push me over are RMD's and social security. Remember you can have revenue of higher than 75k by drawing money from a taxable account in the form of cap gains. Hatton1, I'm not sure I understand what you mean by "huge capital gains taxes". Please explain.

RocDocs: Any analysis would be awesome, look forward to it. The problem is the viability depends on so many factors that are all changing relative to one another. This only seems like a good strategy in the setting of low interest rates where the spread of expected portfolio return is greater than the interest rate on the mortgage. What this is is anyone's guess. The mortgage rate is tied to libor or the CMT or other metric plus 1.25% FHA insurance. At some point interest rates rise to make this a silly strategy. The real value would be letting the IRA money continue to grow, and not have to pay income tax on it until RMD kicks in. The higher this income would be taxed the more viable the strategy. Personally I would use this as a tool to control my taxable income if I was at risk of bumping into an unacceptable tax bracket...although maybe it wouldn't matter because I would be draining the taxable account first. You can see why this analysis is so hard to do, too many moving parts.

SIPA: Personally I don't like these. It's trading one risk for another. In aggregate I think it amounts to locking in lower returns for diminishing volatility. Also seems like they become exposed in a high inflation environment (I know you can buy inflation protected, but they seem like pretty crappy products when I've looked). You also have to give the insurance company a pile of money. I don't really like this idea. What attracted me to the concept of a HECM was the ability to transfer risk to the FHA (of course I pay for that with the 1.25% insurance, but it's not paid unless I actually need to use the line of credit). You have a growing line of credit that is independent on the future appreciation of the asset backing that line. Essentially the FHA assumes the risk of deflation in the housing market in general, or your particular house/neighborhood/city. This seems like a pretty big deal to me. Any time I can transfer risk with little cost I'm excited. I just don't know how to calculate if the sizable upfront fees are offset by the taxable savings and amorphous value of transferring risk.

Regarding sequencing risk: While it is not knowable, you can know to some extent when you are in it. One could set up parameters to start using the line of credit when the portfolio value fell below a certain value, or you could use it. When I look back at rough years for the 4% rule I wonder if something like this would have helped.

I'm going to reach out to a few financial bloggers much smarter than me and see if I can get them to do a write up. I don't even know why I care, as there is no way this program will be around or in its current form when I'm old enough to use it. I'm just intellectually curious I guess

[Hatton]

If you have a large enough taxable account the income it throws off will be more than $75k.  This is what I think RocDoc is referring to.  My taxable account threw off $148k last year in dividends, capital gains, and muni bond interest.  Demuth advocates buying individual stocks that pay no dividends to avoid taxes. This is what I was referring to about huge capital gains to follow this strategy.  To buy a meaning amount of a SPIA you introduce worry about insurance company bankruptcy so I probably will not do this either. First world oversaving problems here I think.