The Key to a Comfortable Retirement

ountless surveys are conducted asking Americans about financial goals. Year after year, the overwhelming response as the top financial goal is to retire as early as possible and live comfortably. Fed up with work, people of all ages and various professions are desperately searching for a way to get out of the rat race, looking forward to the day they can tell their boss to take the job and…you know the rest. Retirement is their most precious dream. But what causes many Americans to fall short of their dream? The inability to maximize cash flow.

There are two components of retirement cash flow: inflow and outflow. Retirement cash inflow can include social security (reduced for early age distributions), pension (if applicable) net rental income, if applicable, cash interest or cash dividends. Retirement cash outflow can include living costs adjusted for inflation, federal income taxes, state income taxes, insurance premiums (continually rising), interest paid on debt outstanding. Maximizing cash flow involves financial planning techniques that increase inflow and minimize outflow without sacrificing the desired retirement lifestyle.

An Expensive Proposition

Before we can plan how to increase our inflow, we need to know what's going to be leaving our pockets. It's fair to say that most Americans tend to live up to their income. The more we earn, the more we spend on our lifestyle, and generally we'd like to be able to sustain that lifestyle to which we've grown accustomed in retirement. A different breed than retirees of past generations, retirees today are younger, more active and eager to enjoy life, all of which requires money.

Not only are we retiring younger, we're living longer, often thanks to advanced healthcare. Another major cost of retirement, healthcare will no doubt continue to rise. To make matters worse, the federal government continues to reduce insurance coverage via Medicare, and corporations recently have been modifying or completely eliminating retiree health plans, thus leaving retirees to pay more.

Consequently, living costs in retirement are significant, not only because we intend on actively enjoying our retirement and maintaining our health, but also because our retirement can last decades, not simply a few years.

Investing and Inflation

So how can we financially plan to sustain our lifestyle in retirement? Living longer requires that we properly invest assets without taking unnecessary risks in order to make the money last as long as possible. During wealth-producing years, investors are more apt to take risks; striving to attain about a 12-percent average return may be practical. But as a retiree, wealth accumulation strategies change to wealth preservation strategies. High-risk investment strategies aren't as appropriate, so investment returns, which are based on more conservative strategies, tend to be lower in retirement based. Earning a respectable net real return during retirement is absolutely necessary. Net real return is defined as the following:

Gross return on investment
Less: Fees associated with the investment
Less: Federal and state taxes
Less: Inflation

The one major component of the equation is inflation. Retirement related expenses continue to rise primarily since, as noted previously, retirees are more active than ever. Add an inflation rate rising every year to the cost of living during retirement and the numbers add up quickly. The consumer price index (CPI), a measure of inflation, is about three percent. During the 70s and 80s the CPI was in double digits. But let's assume an average four percent. With that rate, a 50-year-old striving to semi-retire at 60 living on $100,000 in today's dollars would require $148,000 the first year of retirement. And each year thereafter during retirement living costs increase. By the time this person reaches age 80, the future value of annual living cost will be $324,000. With inflation pushing the cost of living ever higher, we need to figure out where we can minimize our cash outflow.

Mortgages: Just Say No

We know that cash outflow includes many variables. No doubt the major living expense item during retirement is your mortgage. During this last prolonged bull market in the housing industry, the value of houses increased in double digits, far above the five to six percent historical norms. Even so, many Americans faced a relatively large mortgage. For example, buying a $900,000 house and depositing $400,000 would still leave you with a $500,000 mortgage. A fixed rate, 30-year mortgage at 6.50 percent interest means $3,160 per month principal and interest. Real estate tax, home insurance and association fees are extra.

Many positive strategies exist to retire in style. But the best way to accomplish this mission is to have no mortgage. When I present this to clients and classes, most people think this strategy doesn't make sense. They believe or have been told that having the mortgage interest tax deduction is valuable. I contend the opposite.

Going into retirement, one of the largest, if not the largest living expense (cash outflow) is your mortgage. Let's go back to my example to drive home some major points. A 50-year-old financing $500,000 at 6.5 percent pays $3,160 per month principal and interest, nearly $38,000 per year. In the first year of the mortgage, about $2,700 of the monthly mortgage payment applies to interest, totaling more than $32,000 paid in interest for a year. While earning income, it can be presumed the tax bracket is relatively high. One in the 36-percent tax bracket can deduct about $11,500 interest from taxes or less if full deductions are not allowed.

Twenty years into the mortgage, less than half the monthly payment, roughly $18,000 annually, counts toward interest. Through time less interest qualifies for an income tax deduction. In addition, retirees are commonly in a lower income tax bracket, so the mortgage interest income tax deduction is not as valuable. For every dollar of interest paid to the mortgage company, only 20 cents is applied versus 36 cents if one is working. For example, retiree in a lower tax bracket, say 20 percent, may deduct $3,600 interest from taxes.

Sometimes people have a hard time understanding this. "Isn't all the interest tax deductible?" they ask. After all, in wage-earning years, the more income tax deductions the better - all things being equal. Maximizing deductions to offset wages and other sources of income is prudent. But think of it this way: Taxable income is bracketed, and mortgage interest deductions are less valuable when in a lower tax bracket.

Also, if adjusted gross income exceeds $145,950, Schedule A federal deductions are reduced. (Adjusted gross income includes: taxable wages, interest income, dividend income, capital gains, net rental income, net self employed income, social security and pension, and other miscellaneous income such as jury duty, etc.) As a consequence, federal tax deductions are not as attractive compared to the standard deduction for most retirees. Federal tax law provides for a taxpayer to itemize deductions or take a standard flat amount for deductions. Because some retirees may not qualify for significant tax deductions, they file for the standard flat deduction; a married couple over age 65 filing jointly is eligible for $12,000 standard deduction from federal taxes.

As you can see, tax deductions should not be a priority for retirees, cash flow on the other hand, should be. And paying off the mortgage prior to retirement is a way to maximize cash flow. As in the example, not paying $38,000 per year is a very substantial savings to almost anyone's retirement budget.

Being mortgage free also adds flexibility. Without a mortgage, retirees are less inclined to have life insurance covering the outstanding mortgage liability. Beneficiaries of the estate can receive the asset value without a cumbersome debt obligation, and there would be no immediate rush to sell a house.

So how do you become mortgage free? Proper financial planning in anticipation of that special retirement date is important. The sooner you plan, the better. Determine how much you need to live comfortably in today's dollars for retirement. Figure out how many more working years you have prior to full or semi-retirement and develop a program for prepaying the mortgage during those years. The key is to determine how much extra principal is needed in order to enter retirement without a mortgage.

For more aggressive investors, instead of paying down the mortgage until retirement, invest the extra money in an attempt to earn higher net returns above the mortgage rate. Establishing a proper asset allocation is the key to success. Here is one example:

10% of invested assets as an emergency fund
20% of invested assets in fixed income
60% of invested assets in capital appreciation securities
10% of invested in sector securities (gold, energy, etc. depending on the market)

Going into retirement, pull down these invested assets and pay off the mortgage after paying minimal capital gains tax.

Your Most Important Asset

According to the U.S. Commerce Department, personal savings as a percentage of after tax income dropped to nearly one percent in 2005. That is the lowest level of savings since the height of the Great Depression. Clearly, Americans are not prepared for retirement. Taking retirement seriously and implementing strategies today can make the difference between financial failure and financial success. The latter can result in comfortable retirement for you and your family. The secret to retirement lies within your house. Use it as an asset, not a cash flow liability.

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Robert A. Mecca, CFP, MBA, RIA, has been a life-planning consultant and teacher for more than 20 years. Mecca is a fee-only advisor and can be reached at bob@MeccaOnMoney.com. For more information visit www.MeccaOnMoney.com.