Should You Draw Down Savings Before Doing a Reverse Mortgage?

I’ve taken a excerpt from The Lee and Desi Real Estate radio show I appeared on and have added some visuals to make it a little more interesting.

In the 10 years I have been doing reverse mortgages, I have frequently heard a client say they were going to use up their savings before they considered a Reverse Mortgage. I didn’t think anything of it. It seemed reasonable.

Then, I began talking to more financial planners and others in a similar business. Different reasons have been pointed out as to the costs of drawing down assets as well as the impact on the estate associated with that. Here are some of the concerns mentioned:

If the assets are in stocks or stock mutual funds:

• There is the possibility of paying capital gains. If the stock has split and/or appreciated significantly since it was purchased, this tax could be significant. (This may not apply to Mutual Funds.)
• If the stock pays dividends, those dividends will stop being paid. They may be part of your income. That means you’ll need to draw down more assets perhaps sooner.
• If the stock typically grew in value, once it is sold it can no longer grow.
• If the stock has been sold, your heirs will not receive the stepped up cost basis they might have been eligible for if your assets stayed intact. In general, this means that when your heirs inherit an asset, they do not have to pay tax on the difference between what you paid for the asset and the value when they inherit. Check with your financial advisor or tax person to see how this might affect you.

If the assets are in bonds or bond mutual funds:

• Selling the bond or shares are likely to stop the income associated with that bond. Like the example above, this could be a never ending spiral of losing income and needing to sell more assets to make up the loss of income.
• There may also be a loss in the value of the asset that might receive a stepped up cost basis

If the assets are in Cash or CDs:

• Like the bonds, CDs generate income. The loss of this income could, again, cause a downward spiral as above.
• Cash may have some interest associated with it but usually very little. You have the funds in cash so you may easily draw down as needed without having to sell one of the assets above when the timing might be bad. This is good.
• However, as the cash runs out, you may need to convert some of the assets above to cash, even if the time isn’t right.

If the assets are in an IRA or 401(k):

• If you are over age 70 ½, you have no choice but to take the minimum required disposition.
• If you are taking more than the minimum, then you may be paying federal and state taxes at your current rate.
• If you are under 70 ½ and drawing from the IRA, you may be paying taxes you could legally avoid.
• If you have a tax year when you owe no or little taxes, you might consider transferring funds from an IRA to a ROTH IRA. This would allow you to draw funds from your IRA tax free in a year when you might have a tax liability. If they are invested in other than a cash position, you may reinvest them in the same choice if you wish. Or this may be a good opportunity to unload an investment you don’t like. Consult with your tax preparer to determine a dollar amount that would make the most sense.

The value of the reverse mortgage is that it adds a fourth choice to how you draw funds from your assets. The fourth asset is now your home. You now have some positive ways to avoid the negative impact of drawing down assets:

• The reverse mortgage has no tax implications when you draw down on the funds available.
  The unused Line of Credit portion of the FHA Reverse Mortgage grows at the same interest rate you are charged for the money you have used. Since 1989 (the first FHA reverse Mortgage) the rate has ranged from about 10% (remember the late ’80’s and early ’90’s) to 3%.
• The Reverse Mortgage allows you one more choice when cash is needed. You can choose from four asset classes when you need funds. In one case you may use the Reverse Mortgage because you have already drawn the minimum from your IRA and drawing more will cost you in taxes. In another case, you may have determined that you can draw a certain amount of money from your IRA without paying taxes. This then might be your choice.
• Using the Reverse Mortgage may allow the assets to pass to heirs with the stepped up cost basis. This may also allow the home to pass to heirs with the stepped up cost basis if one of the considerations was to sell the home.
• Typically, as people get older, they start moving funds from their growth stock into safer bonds and cash. By having the Reverse Mortgage as the fourth choice, you may find you can leave a higher percentage in stocks allowing for longer term growth and minimize the potential for loss. This also provides a better likelihood you won’t outlive your assets.