Q-and-A With Jonathan D. Pond: Mortgages and 401(k)s

 

I'm a strong advocate of making extra mortgage payments, as long as you're still contributing generously to your retirement accounts, including an IRA, and you also have sufficient cash reserves to make mortgage payments for at least six months should financial adversity strike.

 

Many homeowners think a big mortgage is advantageous, because the mortgage-interest deduction saves taxes. That used to be the case when income tax rates were a lot higher, but rates are much lower now, which diminishes the benefit of mortgage-interest deductions. For example, most homeowners are in the 25 percent income tax bracket, so $10,000 of mortgage interest would save only $2,500 in federal income taxes. That's of some benefit, but it may not be enough to justify a large, long-term mortgage.

 

The main argument against making extra mortgage payments is if you can confidently expect to earn a higher return on investing the money than the amount of your mortgage interest rate. For example, if you have a 6 percent mortgage, but you're confident that you can earn 8 percent on your investments, you may be better off investing the money. But most investors aren't that confident, particularly after the dismal investment results (that's putting it mildly) for 2008. It is probably not prudent in this investment environment to be very confident about high future investment returns, particularly from savings accounts.  

 

I also worry about "high-yield" savings accounts. Any savings account or money market fund paying more than 2 or 3 percent is suspect these days. Don't fall for pitches for "high-yield" investments. The higher the yield, the higher the risk. I recently received an e-mail that touted "no-risk" CDs yielding more than 18 percent. You'd have to send your money overseas, and anyone who does should kiss the money goodbye.  
I recently panicked after losing 30 percent of my 401(k), redistributing my allocations to 94 percent in a stable income fund despite the loss incurred. Since then, the value of my account continues to drop. If I reallocate my 401(k) back to the original distribution (purchasing shares at the currently depressed prices, which are slightly lower than they were when I originally sold at a loss), can I break even, and does this make sense given I plan to retire in nine years? Molly, California

 

You're certainly not alone. Many investors have taken a lot of money out of the stock market and are now confronted with the dilemma of how to move back in, particularly in light of the low interest paid on stable income funds and money market funds—the two safest investment alternatives in 401(k) and most other workplace retirement plans.

 

The main challenge is deciding when to get back into stocks. No one knows when the stock market will revive, but history has shown that when it does, it rebounds very quickly. On the other hand, market conditions could get worse before they get better.

 

My suggestion to you and everyone else who has lightened up on stocks is to gradually reinvest in the stock market throughout 2009. For example, you may want to move 1 to 2 percent of your total investment money (or even more if you're optimistic) back into the stock market each month. That way, you'll avoid making a big move back into stocks in the event prices continue to go down, but you'll have more money in stocks and stock funds to take advantage of the rebound when the market gods smile on investors once again. This strategy will work especially well for those like you, who are many years from retirement, but it will also benefit retirees who still need their investments to grow later in life to meet ever-rising living expenses.  

I've heard some talk about converting a conventional IRA over to a Roth IRA now, because the market is so depressed. What are the factors that I should consider if this is a reasonable option for me? –Michael, Michigan

What you've been hearing is correct. A Roth IRA conversion entails moving money from a traditional IRA into a Roth IRA. You have to pay income taxes on the amount that you convert, but that's why this could be a particularly good time to do so. Because the prices of mutual funds and stocks have been hit so badly, you can move money at a much lower tax cost than would have been possible when prices were so much higher. Then when prices rebound, you'll enjoy even more tax-free income when you begin making withdrawals in retirement, since most withdrawals from Roth IRAs are totally free of federal income taxes.

 

To be eligible for a Roth conversion, your adjusted gross income for 2009 must be no more than $100,000, regardless of whether you're single or married. You can do a Roth IRA conversion any time this year. If you should, but the prices of the investments you transferred continue to decline, you could "undo" the conversion to avoid paying income taxes on the higher balance when you made the conversion. The way to reverse the conversion is to ask the Roth IRA trustee to transfer the converted amount back to your traditional IRA. This is known as a "recharacterization," and, if the original conversion takes place in 2009, it can be done any time until you file your 2009 tax return (including any extensions through Oct. 15, 2010).  

Even if you can get a rate as low as 4.5 percent, refinancing may not be worth the costs and hassles. Also, unless you're able to get a very short mortgage—no more than 10 years in your situation—you run the risk of having to make mortgage payments well into your retirement years.

 

Unfortunately, many homeowners who refinance to take advantage of lower interest rates extend the maturity of their mortgages when the objective should be to pay off the mortgage sooner rather than later. I think you'll probably be OK standing pat, and congratulations on your efforts to pay down a good portion of your mortgage by the time you retire.