April 7, 2017 by HECM Pro
Mr. and Mrs. Smith, both 66, are retired and live in the state of Virginia. Mr. Smith had a very successful career as an aerospace engineer and Mrs. Smith had her own bookkeeping business. They made good money over the years, stayed out of debt, saved diligently, and managed to retire with a paid off house and $1 million in a traditional IRA. By all accounts, the Smiths have done very well for themselves.
Though they have low expenses and are able to live on just their Social Security of $3,000/month, they don’t have much left over at the end of the month to do fun things. They enjoy their home and entertaining friends and family from time to time, but they didn’t envision working for 30 to 40 years just to retire and stay at home all the time. They’re blessed with good health and want to take full advantage of it to see the world.
Before we dig into this further, let’s summarize the Smith’s current financial situation:
- Monthly income: $3,000 from Social Security
- Retirement Account Balance (IRA, taxable): $1,000,000
- Home Value: $400,000
- Mortgage Balance: $0
Though the Smiths want to increase their lifestyle now, they’re very cognizant of the fact that people are living much longer these days. It’s possible they could live for another 20 to 30 years, so they want to make sure their money lasts. They won’t touch the IRA at all until the government requires them to starting taking required minimum distributions (RMD) at age 70 ½. And even then, they’re hoping the IRA money is earning enough to cover the RMDs without dipping into their principal.
Another reason the Smiths want to stay out of their IRA is income taxes. Every dollar they saved and invested in the IRA was pretax, which means it’s 100% taxable upon withdrawal. According to the retirement tax planner at fool.com, the Smiths are not subject to federal income taxes if they live on just their Social Security of $36,000/year. However, the story changes once they start taking money out of the IRA.
Assuming a 4% return on their IRA money (the standard rule of thumb many financial planners use), they’ll earn $40,000/year in their IRA. If they choose to pull out the full $40,000, their federal income tax bill goes from $0 to $4,475/year.
The Smiths really want to enhance their retirement lifestyle now, but they need more income to do it. But they don’t want to start drawing down the IRA yet and they definitely don’t want to incur an income tax bill in the process.
There is good news for the Smiths! As it turns out, a HECM reverse mortgage can serve as the income source they’re looking for. But before we dig into how that might work, let’s cover a few basics.
What is a HECM Reverse Mortgage?
A HECM reverse mortgage allows homeowners 62 years of age or older to convert a large portion of the value of their home into tax-free cash without having to give up ownership of the home or take on a mortgage payment. As long as you pay required property charges such as property taxes, homeowners insurance, HOA dues, etc., no payment is ever required, and the money borrowed doesn’t have to be repaid as long as at least one borrower is permanently living in the home.
Contrary to what many people think, a reverse mortgage is not just a loan of last resort for financially desperate people. Yes, it can often help people who are in a bad spot financially, but it’s also a fantastic retirement planning tool for people who are very well off.
The proceeds from a HECM can be distributed in several ways, including lump sum, monthly term or tenure payments, line of credit, or some combination of all of these. The option that made the most sense for the Smiths is the line of credit because it would give them the ability to grab cash at their leisure with just a phone call.
Crunching the Numbers
Based on a home value of $400,000, the Smiths qualify for a reverse mortgage line of credit worth $220,000 after closing costs. In one shot, they increased their available liquid retirement assets by over 20%! This money is 100% liquid, tax free, and the available credit line will automatically grow larger over time. They will never be asked to make any mortgage payments or pay this money back in this lifetime as long as they pay their property taxes, insurance, and live in the home. This is the perfect way for the Smiths to get their hands on cash to take trips.
The most powerful part of this is the line of credit growth, which automatically gives them access to additional money over time. Assuming a growth rate of 5%, which is reasonable for today, the line of credit would grow as shown in Figure 1 over the next 20 years if they left it untouched.
Note that the growth rate applies only to the unused credit line. There’s no way to predict exactly how the Smiths would use it over time, but this is how the growth would look if they left their available credit line untouched and it grew at 5% for the next twenty years.
Now, obviously, they want to use the money. As you can see, the first year alone they “earn” an additional $11,000 in growth. They could just skim off the gains and increase their lifestyle by $11,000 per year while leaving the original line of credit intact. If they decide to take out more, they can certainly do that at their discretion as well.
The Smiths already have the income they need to cover their regular monthly bills, but they wanted to enhance their lifestyle without dipping into the IRA and incurring a big tax bill. The reverse mortgage line of credit was the perfect solution! They were able to set up an additional source of cash from their home equity without having to sell the house or take on a mortgage payment. Even better, the available line of credit will grow and compound larger over time, giving them access to additional cash. Now the Smiths are having the fun they want and their money will likely last them for many, many years into the future.