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Looking Forward to Paying Off That Home Mortgage Early? Not So Fast!

By Randall K. Barton

Many well-meaning financial planning experts counsel ministers to take extra cash flow each month and budget to make extra mortgage payments. For example, 52 weekly payments (4 extra weekly payments per year), instead of 12 monthly payments, will pay off a 30-year mortgage in just over 23 years.

Over the last several months, some tax advisors have suggested that a recent Tax Court Case1 decided in favor of a minister may allow a lump sum retirement distribution to be classified entirely as tax-free housing allowance, thus allowing a retiree to take a lump sum withdrawal from their church retirement fund and pay off any housing indebtedness, freeing them from mortgage debt during retirement.

While these planning concepts seem to make common sense (who wouldn’t want to pay off their mortgage early?), when examined in comparison to increasing retirement contributions, this apparent good stewardship may be an illusion for ministers that could erode future retirement benefits.

REVEREND STEWARD

Reverend Steward just finished teaching a marvelous stewardship course that discussed the importance of getting out of debt. One of the techniques discussed was to take $100 per month of cash flow and apply it as extra principal against a home loan. With income of $40,000 per year, Rev. and Mrs. Steward felt they should practice what they preached and committed to add $100 to their monthly house payment of $800. This would pay off their new 30-year mortgage 9 years early; now age 35, they would own their home (or a future home) free and clear at age 56 instead of 65. They also committed that at age 56 they would take $900 per month ($800 housing payment plus $100 per month prepayment) and load up their retirement account for 9 years invested in a portfolio of 60 percent equities and 40 percent fixed income, thus providing nicely for their retirement needs at age 65.

REVEREND COMPOUND

Reverend Compound visited ministersbenefit.com and began studying the effect of making extra contributions to an MBA 403(b) retirement account. One technique suggested was to take $100 per month of extra cash flow and defer it into a 403(b) account tax-free, let it compound tax-free, and take it out in retirement as tax-free housing allowance. They have chosen to invest in a portfolio of 60 percent equities and 40 percent fixed income. With income of $40,000 per year, Rev. and Mrs. Compound realized that tax-free compounding coupled with the tremendous tax benefits ministers enjoy would be good planning. At age 35, their new 30-year mortgage would be paid off at age 65, thus providing nicely for their retirement years.

Which ministerial couple is best positioned to provide for their financial needs during retirement, assuming their investment return average is 10 percent per year over 30 years (the expected return of a 60 percent equities/40 percent fixed income portfolio)? (See chart 1.)

At age 65, Rev. and Mrs. Steward own their home free and clear and have $152,292 in their retirement account. Rev. and Mrs. Compound would own their home free and clear and have $226,044 in their retirement account; when coupled with Social Security, this is enough for them to enjoy those "Golden Years" more than Rev. and Mrs. Steward. The lower the long-term rate of return in the retirement account, the less the advantage would be to Rev. and Mrs. Compound. In fact, if the investment return drops to 7.5 percent, the couples would be in about the same financial condition at retirement.

INCOME TAX IMPLICATIONS

What about the tax implications of paying more on your home versus increasing retirement contributions? The extra amount Rev. Steward paid on his mortgage each month should have been classified as tax-free housing allowance but is subject to self-employment taxes (SECA) of 15.3 percent, while contributions to a 403(b) account avoid all taxes within the limits allowed by the IRS. This provides some immediate tax benefits to Rev. Compound that Rev. Steward will not enjoy until he starts contributing to his retirement account.

SHOULD I CHOOSE A 30-YEAR OR 15-YEAR MORTGAGE?

The same tension arises for ministers when deciding between a 30-year or 15-year mortgage.

Rev. Compound chooses a 30-year mortgage at 7.5 percent on a $114,414 loan, making his payments $800 per month. He considered a 15-year mortgage at 7 percent with payments of $1,028, but decided that he would take the extra $228 per month that a 15-year mortgage would cost him and contribute that to his 403(b) account, again, invested in 60 percent equities and 40 percent fixed income.

Of course, you can guess what Rev. Steward did. He went for the 15-year mortgage and after paying off his mortgage contributed the entire payment to a 403(b) account for 15 years. (See chart 2.)

Rev. and Mrs. Steward are behind Rev. and Mrs. Compound at retirement. Again, the lower the rate of return in the retirement account, the less chance there would be for the Compounds to come out ahead.

PASTOR LUMPY

Pastor Lumpy, age 65, just heard some fabulous news. Apparently, a recent Tax Court case suggests there may be no limit on the amount of housing allowance he can take in a single year during retirement. His accountant stays up on such developments and advises him to take a lump sum distribution out of his 403(b) account tax-free (before they close this loophole) and pay off his home mortgage. Rev. and Mrs. Lumpy are thrilled to avoid 15 more years of monthly mortgage payments and pay it off with tax-free dollars.

PASTOR WISE

Pastor Wise subscribes to Pastor, Church & Law and read with interest in the 2001 edition that while the recent Tax Court case may eliminate the annual fair rental value limitation, the case is on appeal. He wonders if he should take the risk or if he would be better off receiving his retirement distributions in installments over 15 years and using them to make the balance of his monthly mortgage payments.

Which retired minister, Pastor Lumpy or Pastor Wise, will be better off financially?

Assuming the interest earned on the retirement account is equal to the interest on the 15-year loan, Pastor Wise is better off financially. Why? Pastor Wise will enjoy a double deduction (interest deduction and housing allowance) as he draws out of his retirement account. Since Pastor Lumpy has no housing payments, he receives no deduction.

Pastor Wise should consider a lump sum distribution only if he pays little or no income taxes and the legal and tax matters are fully clarified.

WAIT A MINUTE!

What if your loan’s interest rate is more than your retirement account earnings? In the 20 percent combined Federal and State income tax bracket, that differential could be as much as 1.5 percent and you would still be ahead financially to receive the double deduction and make mortgage payments. You could also refinance with a low interest adjustable rate loan and actually make a profit on what you earn in your retirement accounts versus the cost of the loan. For example, MBA currently pays 6.75 percent on fixed income retirement accounts, while 1-year adjustable rate loans below 6 percent can be secured in the marketplace today, thus providing Rev. Wise the opportunity to enjoy even more benefits.

What if your adjustable interest rate loan goes up and retirement fixed income rate goes down? Don’t panic. You could simply convert from a periodic payment to a lump sum at a future date and pay off that mortgage, assuming the tax law has been clarified in your favor.

WHAT HAPPENS AT DEATH

Very few retired ministers will benefit financially from taking a lump sum retirement distribution to pay off their home mortgage or to build a retirement home. A major exception would be in the event of ill health, a minister may decide to take a lump sum distribution and pay off a home mortgage so upon death, heirs will inherit a home free and clear rather than a home with a mortgage and a retirement account subject to income tax on the benefits received. Of course, there may be important estate planning reasons to spread out the receipt of retirement benefits after death.

Integrating financial, retirement, tax, and estate planning for ministers is extremely complex. Financial planning principles that at face value seem to make sense sometimes spell bad stewardship when applied to the unique benefits and opportunities that clergy enjoy.

CHART 1


CHART 2

Randall K. Barton is president and CEO of the Assemblies of God Financial Services Group, Springfield, Missouri.

ENDNOTE

1. Warren v. Commissioner, 114 T.C. 23 (2000).

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