Dear Liz: All my friends have said I should get a reverse mortgage to be able to live more comfortably and still stay in my house. I would think our greedy banking system would give you only 50% of value and have a high interest rate that would chew up the remaining value. What is your advice on the merits of this option?
Answer: A reverse mortgage program that lets you tap too much of your home equity wouldn’t be in business very long.
Reverse mortgages allow people 62 and older to borrow against the value of their homes without having to make payments on the debt. Instead, the amount they owe typically increases over time because interest is charged on the loan, and that adds up. Lenders get paid back when the owner moves out, sells the house or dies. If the house is worth less than the debt, the lender (or more often the insurer) suffers a loss.
Too-generous lending standards have already caused trouble for previous iterations of the Home Equity Conversion Mortgage, the federally insured option most often used by borrowers. Too many borrowers grabbed big lump sums up front, straining the program’s reserves and leaving the borrowers with few options if they ran into hard times later. Defaults rose as borrowers failed to pay their property taxes and insurance premiums as required.
The Federal Housing Administration, which insures HECMs, has tightened the rules so that borrowers can access less of their equity upfront. Fees also have increased.
How much you can borrow using a HECM depends on your age, the home’s value and current interest rates. Interest rates for lump-sum withdrawals are fixed, while those for lines of credit you can tap over time are variable.
You’ll certainly get a better (or at least less expensive) deal if you borrow 60% or less of your home’s value. The mortgage insurance premium for loans below that level is 0.5% of the home’s appraised worth under the new federal government rules that go into effect Monday. Those borrowing more than 60% face a premium equal to 2.5% of the home’s value. That’s in addition to a 1.25% annual mortgage insurance premium.
There’s no getting around the fact that these are expensive and complex loans. They’re usually not a great choice for people who have other assets to tap. They also can prove a land mine for people who drain their home equity too early and wind up with no resources later in life. On the other hand, they can provide a more comfortable retirement for those who would otherwise be strapped for cash, particularly if the borrowers opt for a steady stream of monthly payments rather than the upfront lump sum.
If you are considering a reverse mortgage, you should talk to a fee-only financial planner who is familiar with the program and who can review your other alternatives.
Dear Liz: I’m 64 and lost my last full-time job a year ago. I have since exhausted my unemployment benefits and been on and off food stamps. (I’m waiting to get back on them right now because my temporary-to-permanent job didn’t become permanent after all.) Fortunately I almost never need to go to a doctor, or if I do, I don’t know that I do and can’t afford to find out. I have about $3,000 in emergency savings, and my IRA is about $15,000. I was fortunate enough to sell a home in Hawaii 20 years ago, but I managed to run through all the money. My income when I was working full time was only $26,000 a year. I don’t know what to do, and I don’t know why I listen to all these financial programs that seem to target twentysomethings or people with retirement savings and comfortable incomes. They do not speak to my situation. My priority isn’t saving for retirement. It’s paying the bills.
Answer: Financial programs are, at least to some extent, concerned about the entertainment value of their programming. They often focus on people who fit their audience demographics and whose problems have satisfying solutions. That’s why the people featured tend to be younger or to have resources, because those are the ones who typically can recover from past mistakes and get their finances on track.
When people have no income, there’s not much financial advice to give. And when they’re in their 60s and have virtually no retirement savings, there’s no way to “catch up.”
That doesn’t mean your situation is hopeless, but it does mean you’ll have to hustle to stay afloat.
Finding a full-time job at this point is a long shot, so part-time work and Social Security probably will provide your income in the coming years. Social Security might replace as much as 40% of your previous low income (the replacement rate is lower for higher earners), but that still leaves you with a substantial gap to fill.
Ideally, you would hold out until age 66 before applying so you can get your full Social Security benefit. You’re eligible for benefits now, but your checks will be permanently reduced if you start early and your earnings could potentially reduce your check further under the earnings test (which you can learn more about at http://www.ssa.gov/oact/cola/rtea.html). The benefits that are withheld aren’t lost, because at full retirement age your monthly check would be increased to account for the withholdings. You’ll have to balance whether those disadvantages outweigh the upside of starting a guaranteed income now.
By the way, if you’ve ever been married and the marriage lasted at least 10 years, you may qualify for spousal or survivor benefits (even if the marriage ended in divorce) that could exceed the benefit you’ve earned on your own record. You can discuss your options by calling the Social Security Administration at (800) 772-1213.
You’ll need to look for ways to reduce your expenses so that you can get by on whatever income you receive. If you qualify, the federal Section 8 program could help pay for housing (start at Benefits.gov to see what programs are available). Some of the other ways to reduce housing costs — the biggest expense for most people — include getting a roommate, becoming a live-in caregiver for an older person or a family with kids, or becoming an apartment manager or the caretaker of a property.
At 65, you’ll qualify for Medicare. Although this government health insurance program for older Americans doesn’t cover everything, you will have access to healthcare again.
Dear Liz: I inherited my brother’s Roth IRA about three years ago. I find it hard to get any information about non-spousal inherited Roths. Can you tell me more about this type of Roth IRA?
Answer: It may be unfortunate that you didn’t ask sooner.
When a spouse inherits a Roth IRA, he can roll it into his own Roth IRA, and it’s as if he or she was the owner of the inherited funds all along. There’s no minimum distribution requirement, so the money can continue to grow.
If you’re not a spouse, you have the option of transferring it into an account titled as an inherited Roth IRA. You also have the option of taking distributions over your lifetime — which means keeping the bulk of the money growing for you tax-free — but to do that you must begin taking required minimum distributions by Dec. 31 of the year after the year in which the owner died.
If you didn’t start these required distributions on time, you have to withdraw all the assets in the account by Dec. 31 of the fifth year after the year your brother died, said Mark Luscombe, principal analyst for CCH Tax & Accounting North America. You won’t have to pay taxes on this withdrawal, but it would have been better to let the money continue to grow tax-free in the account.
Dear Liz: I am 64. My grown children, ages 23 and 25, are the beneficiaries of my retirement accounts. I have a Roth IRA, a SIMPLE IRA and a Rollover IRA. When I die, what will be the tax consequences for them? Will they have to pay any tax upon inheriting the accounts, and will they have to pay any tax when they withdraw the money over time?
Answer: If your estate is worth less than $5 million, it’s unlikely it will incur federal estate taxes. Some states have lower exemption limits and a few have inheritance taxes. New Jersey and Delaware have both. An online search for “state estate and inheritance taxes” should turn up the situation for your state.
Your children won’t have to pay income taxes on distributions from your Roth, but unlike you or a spouse they are required to take distributions once they inherit the account. They can either do so within five years of your death or they can opt to spread the distributions over their lifetimes (which is usually the better option).
Minimum distributions also will be required from your IRAs. Your heirs will have to pay income taxes on those distributions.
Advise your children to consult a tax pro after you die, since these accounts need to be properly handled and titled to get the most benefit.
Dear Liz: I am a CPA and fairly knowledgeable about investing, but I have a question about my IRAs. I am 58 and my husband is in his mid-80s. We both are retired with federal pensions and no debt other than a mortgage. My plan is to start taking money annually from my traditional IRA in two or three years. I want to reduce the required minimum distribution I will need to start taking at age 701/2 and lessen the tax impact at that time. Should I put these annual withdrawals in my regular investment account or should I put them in the Roth IRA? My goal is to lessen the tax impact on my only child when he ultimately inherits this money. Does my plan make sense?
Answer: Your letter is proof that our tax code is too complex if it can stymie even a CPA. Still, it’s hard to imagine any scenario where you’d be better off accelerating withdrawals from an IRA and putting them in a taxable account.
A required minimum distribution “is merely a requirement to take the money out anyway,” said Certified Financial Planner Michael Kitces, an expert in taxation. “All you’re doing by taking money out early to ‘avoid’ an RMD [required minimum distribution] is voluntarily inflicting an even more severe and earlier RMD on yourself.”
In other words, you’d be giving up future tax-advantaged growth of your money for no good reason.
What might make sense, in some circumstances, is moving the money to a Roth. You can’t make contributions to a Roth if you’re not working, because Roths require contributions be made from “earned income.” What you can do is convert your traditional IRA to a Roth, either all at once or over time. You have to pay taxes on amounts you convert, but then the money can grow tax-free inside the Roth and doesn’t have to be withdrawn again during your lifetime, since Roths don’t have required minimum distributions. Whether you should convert depends on a number of factors, including your current and future tax rates and those of your child.
“In other words, if your tax rate is 25% and your child’s is 15%, just let them inherit the [traditional IRA] account and pay the lower tax burden,” said Kitces, who has blogged about the Roth vs. traditional IRA decision at http://www.kitces.com. “In reverse, though, if the parents’ tax rate is lower … then yes, it’s absolutely better to convert at the parents’ rates than the child’s. In either scenario, the fundamental goal remains the same — get the money out when the tax rate is lowest.”
If you do decide to convert, remember that the conversion itself could put you in a higher tax bracket.
“It will be important not to convert so much that it drives up the tax rate to the point where it defeats the value in the first place,” Kitces said. “Which means the optimal strategy, if it’s to convert anything at all, will be to do partial Roth conversions to fill lower tax brackets but avoid being pushed into the upper ones.”