Menu

Use a reverse mortgage line of credit to preserve your 401(k) or IRA

Use a reverse mortgage line of credit to preserve your 401(k) or IRA

When stock market losses happen during retirement, they compound the impact of withdrawing money from your 401(k) or IRA.

Imagine if you withdraw 5 percent of your retirement account balance at the beginning of the year for living expenses. In a perfect world, the account value would grow 5 percent the rest of the year based on investment performance, essentially replacing what you withdrew.

But we don’t live in a perfect world. Consider what would happen if you withdrew 5 percent at the beginning of the year, then a down market caused another 10 percent drop in the account value. Now, after just one year, you have 14.5 percent less money than what you started with.

But it gets worse. To withdraw the same dollar amount in year two that you did in year 1, you would have taken out about 5.8 percent of the account value at the beginning of the year. If you do that, the account will have to grow nearly 20 percent for the year to get back to where it started on the first day of your retirement.

Now imagine that instead of making that 5.8 percent withdraw in year 2, you had another source of funds. You essentially left your retirement account untouched. If so, the retirement account would have to grow 14.5 percent to get back to where you started.

But let’s say instead it only grew 8 percent. Now you’re less than 8 percent short of where you started. So you tap the alternative account at the beginning of year 3, leaving the retirement account untouched for a second year. And it grows another 8 percent. Now it’s back where it was at the beginning of retirement, and you can confidently withdraw from it during year 4 of retirement.

The question is, where is this alternative source of retirement income coming from?

The alternative: a reverse mortgage line of credit

If you meet the eligibility requirements, you could use a reverse mortgage line of credit.

A line of credit is one of several payment options available on a Home Equity Conversion Mortgage (HECM), which is a federally insured type of reverse mortgage. Like with any reverse mortgage, an HECM line of credit could be available if you’re at least 62 years old and have a qualifying property.

The amount available on a reverse mortgage line of credit will depend on your age, the value of your home and the current interest rate environment.

For example, if you are 65 years old and own 100 percent of a home valued at $400,000, you can obtain a line of credit of about $206,000 after fees and costs have been deducted.

One of the key features of an HECM line of credit is that any unused portion will grow at a market interest rate, in some cases as much as 5 percent or more annually.

Also, you only pay interest on the funds you borrow, not on the total line of credit available. And the funds you borrow plus interest are not due to the lender until you pass away, move out of the home or sell it. There are no monthly payments made to the lender.

How it works

Having this credit line available can help you minimize the impact of market losses on your 401(k) or IRA.

Imagine you’re starting retirement today with $500,000 in your 401(k) or IRA. You decide to withdraw $25,000 the first year and increase that by 3 percent each subsequent year to account for inflation. This illustration also includes hypothetical rates of return on the investment account over ten years. For simplicity, the chart assumes the retiree makes an income withdraw at the beginning of each year.

Starting balance Annual withdrawal on January 1 Remaining balance after withdrawal Annual rate of return on investment performance Ending year balance in retirement account
$500,000 $25,000 $475,000 -8% $437,000
$437,000 $25,750 $411,250 +5% $431,813
$431,813 $26,523 $405.290 +3% $417,448
$417,448 $27,318 $390,130 -3% $378,426
$378,426 $28,138 $350,288 0% $350,288
$350,288 $28,982 $321,306 +18% $379,141
$379,141 $29,851 $349,290 +9% $380,727
$380,727 $30,747 $349,980 -12% $307,982
$307,982 $31,669 $276,313 +4% $287,366
$287,366 $32,619 $254,747 0% $254,747

In this scenario, withdrawals and a few bad years of investments returns have depleted this retiree’s account nearly in half after ten years.

What happens with a reverse mortgage line of credit

The next hypothetical scenario will use the same starting balance and the same annual rate of return on the retirement account’s investment performance. The difference is that, instead of withdrawing from the account after down or flat years, the retiree is this scenario taps a reverse mortgage line of credit to preserve what’s left of the retirement account. In each of the years with a $0 withdrawal, the retiree drew funds from the reverse mortgage line of credit instead of this retirement account.

(In this scenario, if the retiree is 70 1/2 or older, the IRS would require a minimum distribution from the retirement account if it’s a tax-qualified plan like a 401(k) or IRA.)

Starting balance Annual withdrawal on January 1 Remaining balance after withdrawal Annual rate of return on investment performance Ending year balance in retirement account
$500,000 $25,000 $475,000 -8% $437,000
$437,000 $0 $437,000 +5% $458,850
$458,850 $0 $458,850 +3% $472,615
$472,615 $27,318 $445,298 -3% $431,939
$431,939 $0 $431,939 0% $431,939
$431,939 $28,982 $402,957 +18% $475,489
$475,489 $29,851 $445,638 +9% $485,746
$485,746 $30,747 $454,999 -12% $400,399
$400,399 $0 $400,399 +4% $416,415
$416,415 $0 $416,415 0% $416,415

 

Employing this strategy, the retiree has preserved more than 83 percent of his or her original balance after ten years.

The retiree tapped the reverse mortgage line of credit five times in the first ten years, withdrawing a total of just under $145,000. That amount, plus any additional funds the retiree borrows, plus interest, will be owed to the lender when the loan closes.

Using those mentioned above 65-year-old with a $400,000 home, the retiree has tapped a large percentage of the original $206,000 credit line. But keep in mind the line of credit will grow each year. Assuming the credit lines grows 4.5 percent a year, the retiree would still have $138,600 from which he or she could borrow in later years.

Also keep in mind that in some years, you could withdraw portions from both the retirement account and the line of credit to preserve the balances of both.