Many higher net worth individuals, as well as their advisors, are beginning to investigate home equity as a potent risk management tool. Because there was no efficient means to access home equity historically, financial professionals avoided it in retirement planning. Up to very recently, the only alternatives to make use of home equity were to sell the property or refinance it while taking on a monthly payment obligation, but home equity loans are now an option.
Pensions, unlike home equity or assets, were once considered the cornerstone of a successful retirement plan. However, asset-based retirement planning has become more popular and seniors own homes worth close to $10 trillion. The availability of reverse mortgage options nowadays also makes it appealing to consider home equity when creating a thorough retirement plan.
Homeowners can access up to $4 million in income-tax-free earnings from the equity they’ve accumulated through reverse mortgages. Because of this, they have unheard-of ability to access funds that would normally be inactive. These funds can be a great hedge against hazards to the financial portfolio and property value that could derail a retirement strategy.
Home equity can offer a flexible choice in conjunction with hedging to pay for long-term care costs, taxes, and other unforeseen events. Since there are no monthly payments necessary, these funds can be used without having an influence on the household budget. This capital access may be able to give a financial plan options, liquidity, and flexibility that would otherwise not be possible.
Protecting Cash Flow
Refinancing to a reverse mortgage for those entering their golden years with an existing mortgage can increase household cash flow by removing the monthly mortgage payment. With the additional cash flow savings, it will be possible to balance the monthly budget, postpone Social Security or retirement plan payouts, and even control asset distribution rates.
Consider a 65-year-old retired couple who own a $2.4 million home with a $600,000 outstanding loan and a $2,500 monthly mortgage payment. Assume that they have a $1.5 million investment portfolio, with a 6% annual dividend rate needed to cover their costs. This is not optimal because most financial counselors would consider 6% to be an excessively high rate. Fortunately, there are ways to lower that rate.
This couple can lower their asset distribution rate from 6% to 3.5% by paying off the lien and removing their $2,500 monthly payment with a proprietary reverse mortgage. To put it simply, this shifts a portion of their assets from their real estate portfolio to their investment portfolio, giving them more flexibility and liquidity in their later years. Additionally, this “transfer of wealth” could not only occur at a net-zero cost to the estate, but it may even increase the legacy value depending on house appreciation and investment returns.
Risk Management for Long-Term Care
Long-term care expenses can be astronomical, terrifying, and unavoidable. According to a report by the U.S. Department of Health and Human Services, 70% of Americans will need long-term care. Growing older is a costly endeavor. However, medical advances are significantly extending our lives. According to studies, 50 percent of all five-year-olds currently alive can expect to live to be 100 years old. The average American could retire earlier than they did as young professionals. A new, sizable cohort of centenarians is coming; are we prepared? Are centenarians willing to pay for further years of retirement?
We will need to investigate the cultural repercussions of this current paradigm and how we plan and save for an extended retirement in order to face the 100-year life. We must adopt new strategies for retirement planning and finding sources of money. And keep an eye out for fresh ways to control risk that could derail a prosperous retirement. Long-term care will become more necessary as the elderly population grows, and home equity can be employed as a hedge against the risk of portfolio depletion it poses.
Reverse mortgage proceeds can be used to supplement the benefit payment from a hybrid life insurance policy, fund a current insurance or long-term care policy, or self-fund the risk exposure. Additionally, because no payments are ever necessary for as long as the borrower resides in their house, they are able to age in place, which is something that 77% of all adults, according to a recent AARP survey, would prefer to do.
Minimizing Tax Risk
No one can foretell the future, but we can use what we see to draw some generalizations. We are aware of the federal government’s significant budget deficits, historically low income tax rates, and high estate tax exemption rates when it comes to taxes. One may easily draw the conclusion that something must be sacrificed, and it is highly likely that it will be higher taxes on income rates and reduced estate tax exemption rates.
The exemption amount for estate taxes in 2022 is $12,060,000 per individual. Without any legislative changes, that rate will return to the 2016 figure of $5 million after December 31, 2025. Higher net worth individuals could prepare for this transition by utilizing the income-tax-free proceeds from a reverse mortgage to maximize their gift tax allowances before 2026, as reverse mortgage loan amounts can reach $4 million. Giving to irrevocable life insurance trusts (ILITs) can also be a wonderful way to move money out of an estate that might be subject to estate taxes.
Another method of protecting against the hazards of income and estate taxes is through Roth IRA conversions. It can be difficult to have the cash on hand to cover the conversion’s first tax obligations. A reverse mortgage line of credit, which can be accessed when needed to cover the conversion tax obligations, might be the answer.
Consider a 64-year-old man who is now paying 22% in taxes and has a $750,000 home and $1.2 million in investments. He can continue to pay taxes in that tax bracket by making a number of partial Roth conversions, paying the federal taxes with a reverse mortgage line of credit, and finally converting all of his retirement assets to a Roth free of having to make a principal or interest payment each month.
The tax benefits of Roth conversions vary depending on the circumstances, but they may include protection from Medicare surtaxes and income- and Medicare-bracket jumps. The effect of retirement payouts on Social Security is another factor to take into account. Let’s say that the only other source of retirement income for our fictitious 64-year-old is the roughly $70,000 in Social Security benefits he and his wife will receive each year. If he wants to add an extra $100,000 a year from retirement savings, he will pay no taxes on the money if it comes from a Roth. But without the conversion, 85% of his Social Security income as well as his IRA distribution will be subject to taxation.
The Bottom Line
Risk is a scary thing. While it cannot be entirely eliminated, it can be controlled. It’s time to investigate the viability of this untapped resource because home equity can be a significant instrument for risk management in retirement. If you have any questions or concerns about reducing your retirement risk with a home equity loan, please don’t hesitate to reach out to our professional and knowledgeable staff at Fairfax Mortgage Consultants today.
