Chris Johnson, CFP® | Source | Financial Planner at Affiance Financial

Prompt: Pros and cons of paying off a mortgage before retirement

Pros:
• Paying off your mortgage before retirement reduces fixed monthly expenses, easing the strain on your retirement income.
• Without a mortgage, you gain flexibility to allocate funds toward other priorities such as healthcare, travel, hobbies, or supporting family.
• For many, paying off your mortgage can provide peace of mind and a greater sense of financial security.

Cons:
• Using cash, investments, or other income sources to pay off your mortgage may reduce your liquidity. While you eliminate your monthly mortgage payment, your home remains an illiquid asset.
• There’s an opportunity cost to paying off your home, especially if your mortgage has a low interest rate. You might be able to earn more by investing the funds or keeping them in a high-yield savings or money market account.
• If you use tax-deferred accounts, like a Traditional IRA or 401(k), to pay off your mortgage, you may incur income taxes on the withdrawal.
• Making a large lump-sum payment to pay off your mortgage could negatively impact your long-term financial plan. This is especially true if your monthly payments are sustainable based on your income, assets, and budget.

Common Mistakes:
Many people overlook the opportunity cost of using cash to pay off a low-interest mortgage. They fail to consider how this decision might impact their long-term financial outlook, by not saving or investing in other ways.

Other people underestimate the importance of maintaining liquidity for unexpected expenses, such as healthcare or other emergencies. Putting all – or most – of your assets toward your home may leave you unprepared for other major expenses.

Advice for Those Considering It:
If you are trying to decide whether or not to pay off your mortgage, take a holistic view of your financial situation and try to assess both the immediate and long-term implications. It’s important to weigh the emotional benefits of being mortgage-free against the financial trade-offs, including liquidity and potential investment growth.

Impact of Mortgage Interest Rate on the Decision:
Compare your mortgage interest rate with the expected return on your savings or investments. For example, if your mortgage rate is 3% and you can earn 3.5% in a high-yield savings account, holding onto your cash may be more advantageous. You also need to consider the tax implications. If paying off the mortgage requires tapping into accounts that will trigger income taxes or capital gains, you need to factor in the cost of taxes relative to the amount being saved on mortgage interest.

1. Tell me whether in your expert opinion you agree that: One reason it is not advisable to leave the account behind is that your former employer controls the plan, meaning that the former employer can alter the plan rules, change investment choices, and limit how often you (as the owner of your account) can do something with that account’s money?

Yes, these points are valid considerations. Your former employer (or their selected plan administrator) has the authority to change plan rules, including investment options, administration, and fees. If they change plan providers or increase costs, you won’t have a say in those decisions.

Once you leave a company, you may face challenges in accessing support or executing transactions efficiently. Some plans limit how frequently you can rebalance or withdraw funds, which may reduce your flexibility in managing your retirement savings. Additionally, former employees often don’t receive the same level of customer support or guidance as active participants.

However, some 401(k) plans offer low-cost investment options, and it’s important to remember that your money remains yours. 401(k) plans are also governed by ERISA (Employee Retirement Income Security Act), which includes fiduciary rules designed to protect participants—whether active or former employees—from excessive fees, mismanagement, or unfair restrictions. Evaluating these factors is key when deciding whether to leave your 401(k) behind or move it.

2. Tell me whether in your expert opinion you agree that: It becomes harder to keep track of your account. One reason for that is that account owners tend to check on accounts in a former workplace less often. In addition to simply not keeping up with old accounts, many account owners tend to misplace, forget, or otherwise lose track of access information such as user names and passwords for accounts that they check less often. A consequence of loss of contact with an account is that it tends to be harder to maximize returns in an account that you’re checking less often.

Yes, whether you make multiple job changes during your career or time simply passes and it’s not at the forefront of your mind, it’s very easy to forget about an old 401(k) plan. According to Capitalize, a company that specializes in 401(k) rollovers, as of May 2023, one in four (25%) 401(k) plans have been left behind or forgotten ($1.65 trillion in assets).

If you choose to leave your 401(k) with a former employer, it’s essential to maintain a record of the account and check it periodically. A helpful strategy is to create an annual net worth statement, which not only helps track all assets but also provides insight into your financial health over time.

Although checking the account less frequently doesn’t necessarily mean sacrificing returns (especially with low-cost investments or automatic rebalancing), infrequent checks can still lead to missed opportunities for adjustments, especially if your goals change.

If you roll the old 401(k) into a new employer’s plan, you might find the new plan’s investment options to be more limited or higher cost. On the other hand, rolling it into an IRA gives you more investment choices but requires discipline in its management to avoid poor investment choices or neglecting periodic rebalancing.

3. Tell me whether in your expert opinion you agree that: In contrast, when you roll over a 401(k) account from a former workplace into an account in a new workplace (if the new plan permits) or into an outside IRA, you are more likely to stay informed about rule changes in the new workplace plan, you can keep contributing to the account, and you can keep receiving employer contributions including any company matches.

Yes, you are more likely to stay informed about the administration of a 401(k) plan with your current employer than with a former employer. If rolling over into an outside IRA, you will need to monitor IRS regulations, such as contribution limits and income thresholds. It is still imperative to weigh the advantages and disadvantages of the new plan and if you will be better off by consolidating funds or keeping them in your current 401(k)/IRA.

Regardless of whether you roll over an old 401(k), if you meet the new employer’s eligibility criteria, you can contribute to their plan and receive any available employer match. However, rolling over an old 401(k) does not impact your eligibility for new contributions or employer contributions in the new plan.

4. Tell me whether in your expert opinion you agree that: When you roll over a 401(k) account from a former workplace into an outside IRA, you:
a. Can keep contributing to the account.

This is not always the case and depends on the type of account. Once an employee separates from an employer, they are no longer eligible to contribute to the same 401(k) plan.

If the 401(k) is rolled into an IRA, the ability to contribute depends on earned income and IRS contribution limits. Unlike 401(k)s, IRAs have lower annual contribution limits, and deductibility may be restricted based on income and employer plan participation. Failing to follow IRS rules could result in excess contribution penalties or unexpected taxes. Understanding these differences is essential before making a rollover decision.

b. Are more likely to be able to find investment options that are relatively stable and able to resist roller-coasting in value when the market hits a pothole (relative to investment options in the 401(k) at your former workplace).

Rolling your 401(k) into an IRA provides greater investment control, as 401(k) plans are limited to employer-selected options. In an IRA, investors have access to a broader range of investments, including stocks, bonds, ETFs, and mutual funds, which may allow for greater diversification and lower-cost options.

However, more choices do not automatically mean more stability. Investors may unknowingly select higher-risk investments compared to the curated options in a 401(k). While employer-sponsored plans offer guardrails that can help protect against impulsive decision-making, an IRA requires greater discipline to manage risk effectively. Ultimately, aligning investment choices with long-term goals, risk tolerance, and time horizon is essential to navigating market volatility successfully.

c. Are more likely to be able to find investment options that offer guaranteed income, especially without surrendering your money.

Yes, IRAs often provide more investment options that can generate stable income. While government-backed securities like U.S. Treasuries offer stated guarantees, external factors like market risk, inflation, and interest rate fluctuations can still impact overall purchasing power and investment performance.

5. Tell me whether in your expert opinion you agree that: Rolling over a 401(k) from a former workplace into a new employer’s plan or into an outside IRA eliminates the need to keep up with rule changes at the old plan. Meanwhile assets can keep growing on a tax-deferred basis. In the case of a rollover to a traditional IRA, new contributions trigger a tax deduction and your investment choices are almost certain to be vastly wider than they were in the account in the former workplace.

A rollover may help avoid the hassle of monitoring old plan rule changes, while keeping assets tax deferred. However, tax status remains unchanged unless a distribution or Roth conversion occurs. Whether you leave the 401(k) with your previous employer, roll it into a new employer’s plan, or transfer it into a traditional IRA, the tax treatment stays the same.

When rolling over to a traditional IRA, new contributions may or may not be tax-deductible, depending on income, filing status, and employer plan participation. It's essential to review fees, investment choices, and tax implications before making a decision, as IRAs often provide broader investment options, while 401(k) plans may offer institutional funds with lower fees.

• What has been the historical performance of money market funds / have people ever lost money?
According to the financial research platform Y-Charts, the historical long-term average U.S. Money Market Treasury yield is 2.97%, and the current yield is 5.33% as of September 26, 2024. While money market funds are considered low-risk, highly-liquid investments, it is possible to lose money in money market funds. Your principal can be eroded by fees, inflation, and price fluctuations. Money market funds are not FDIC-insured and don’t guarantee a return of principal. Money Market accounts are subject to the same risks, but they are insured by the FDIC and may also be insured by the National Credit Union Administration (NCUA).

• What are some of the factors affecting yields – (e.g. interest rates, market conditions)?
Yields on money market funds are largely dependent on the federal funds rate. As interest rates rise and fall, so do the yields of money market funds. The federal reserve’s goals for the U.S. economy are price stability, full employment, and economic growth. One way the federal reserve accomplishes its goals is by setting interest rates. For example, higher inflation leads to the Fed raising interest rates, which in turn makes yields on money market funds more attractive.

Other factors include the supply and demand for money market instruments, investor sentiment, and economic factors such as inflation, GDP, and unemployment rates.

• Any tips for maximizing returns in the current environment / expert analysis.
In the current environment, you can maximize returns by searching for competitive yields, monitoring prevailing interest rates in the market, and evaluating fees associated with money market instruments. Money market funds and money market accounts are a good option for individuals that are earmarking their cash for specific short-term goals (one year or less), and want to earn a better yield than what they would receive from a standard checking or savings account.