Does it make sense to pay off the mortgage? And what about investing in municipal bonds?
This week, those "Ask the Experts" questions are answered by Michael Tate, a CPA and investment adviser in Sacramento, Calif.
QUESTION: I don't trust Wall Street, but I need to invest somewhere. Would municipal bonds be a reasonable place to invest?
ANSWER: Municipal bonds can be a great component of a diversified portfolio. But I would be careful in putting all your eggs in one basket. Depending on the size of your investment, you might be better off utilizing an index-type mutual fund to increase your diversification in this asset class.
For background, a tax-exempt bond fund (sometimes known as a municipal bond fund or muni bond fund) invests in tax-exempt municipal debt issued by state governments, counties, cities or other political districts. For a shareholder, the key feature of these bond funds is their advantageous income tax treatment, which is generally the same as individual municipal bonds.
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As with individual municipal bonds, the income generated by a tax-exempt bond fund is generally tax-free at the federal level. Likewise, the dividends paid by these funds also may be exempt from state and local taxes. However, the dividends would likely avoid state income tax only for that portion attributable to securities issued in your home state.
Depending on your tax bracket, the after-tax return from a municipal bond fund could actually be higher than that of a taxable bond fund.
One word of caution: If you are subject to the alternative minimum tax (AMT), you must include interest income from municipal securities unless they are specifically exempted from the AMT. I would advise consulting with your tax adviser on your situation.
Overall, the strengths of tax-exempt bond funds include current income, tax benefits and possible lower risk. The trade-offs are generally modest returns, susceptibility to interest rate/inflation risk and less diversification.
Q: My father recently retired at age 71. He can live comfortably with his Social Security and the required withdrawals from his IRA. Since that is possible, I persuaded him to pay off his $120,000 mortgage with his savings. He doesn't need the $850 monthly mortgage savings to live well. What investment would make the best use of his money at his age? Since he is retired and doesn't have income from actual work, opening a Roth IRA is not an option.
A: We are asked this question a lot: Should I pay off my home mortgage? In your situation, it does not sound like your father is getting any tax benefit from his mortgage interest, so that is one reason to pay off his mortgage.
Looking at his interest rate, you need to decide if you could do better by investing elsewhere. For example, assuming the mortgage interest rate is 5 percent, you would need to do better than that to justify investing in the markets.
In this example, we are not taking into consideration any tax benefits. When we run the scenario of paying off the mortgage vs. investing the funds, it really does not make much difference in the long run from a net worth standpoint.
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I have found this decision is a personal preference: Some people want to own their home and not owe anyone, while others are not concerned about carrying mortgage debt because they feel they can do better in the market with their investable assets.
One negative I hear about is the liquidity issue. Some worry that if they pay off their mortgage using savings or other assets, they will not have access to cash in case of an emergency. This can be true but is usually resolved by opening a line of credit for emergency use. Just something to consider.
I would imagine at 71 your father is not looking to take much risk in the stock market. If he truly does not need the funds, I would probably lean toward paying off the mortgage, but please take into consideration the other points mentioned above.
