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Home equity is a powerful risk management tool that many higher net-worth individuals and their advisors are starting to explore.
Historically, financial professionals ignored home equity in retirement planning for a simple reason – there was no effective way to access it. Not long ago, the only ways to exploit home equity were to sell the home or refinance it and take on a monthly payment obligation.
Also, pensions were once thought of as the cornerstone of an effective retirement plan, not home equity or assets. But retirement planning has shifted to be more asset-based. Seniors hold nearly $10 trillion in home equity according to the National Reverse Mortgage Lenders Association. In addition, today’s reverse mortgage solutions make including home equity in a comprehensive retirement plan an attractive option.
With reverse mortgages, homeowners can tap into the equity they’ve accrued, up to $4 million in income-tax-free proceeds. That gives them unprecedented access to funds that would otherwise lay dormant. These monies can serve as an excellent hedge against property value and investment portfolio risk – risks that could disrupt a retirement plan. In addition to hedging, home equity can provide a flexible option to cover long-term care expenses, taxes, and other unexpected events. These funds can be accessed without impacting the household budget since no monthly payments are required. This access to capital can provide liquidity, options and flexibility to a financial plan that might not otherwise be available.
Safeguarding cash flow
For those going into their later years with an existing mortgage, refinancing to a reverse mortgage can boost the household cash flow by eliminating the monthly mortgage payment. That extra cash flow savings can balance the monthly budget and afford an opportunity to delay Social Security or retirement plan distributions and even manage asset distribution rates.
For example, consider a 66-year-old retired couple with a $2.4 million home, and an existing lien of $600,000 with a monthly mortgage payment of $2,500. Let’s say they have an investment portfolio of $1.5 million, from which they will need a 6% annual distribution rate to pay for their expenses. This is not ideal, as most financial advisors would find 6% too high of a rate. Fortunately, that rate can be reduced.
With a proprietary reverse mortgage, this couple can pay off the lien, eliminating their monthly payment of $2,500, which allows them to reduce their asset distribution rate from 6% to 3.5%. Essentially this transfers some of their wealth from real estate to their investment portfolio, affording them greater liquidity and flexibility throughout their later years. Additionally, depending on the home appreciation and investment returns, this “transfer of wealth” may not only be at a net-zero cost to the estate but could enhance the legacy value as well.
Managing long-term care risk
The costs associated with long-term care can be massive, frightening, and unavoidable. A U.S. Department of Health and Human Services study predicts that 70% of Americans will require long-term care.
Getting older is an expensive proposition. Yet, medical marvels are drastically increasing our lifespans. The Stanford Center on Longevity estimates that half of all five-year-olds alive today can expect to reach an age of 100 years. Americans could spend more years in retirement than they did as working adults. Are we ready for a new, massive demographic of centenarians? Are centenarians prepared to fund additional decades in retirement?
To confront the 100-year life, we will need to explore the societal implications of this new reality and how we budget and plan for an extended retirement. We need to approach retirement planning – and sources for retirement funding – in new ways. And look for new tactics to manage risk that could thwart a successful retirement.
With an ever-expanding aging population, the need for long-term care will surely increase, and home equity can be used as a hedge against the risk it presents to portfolio depletion.
Proceeds from a reverse mortgage can be used to fund an existing insurance or long-term-care policy, supplement the benefit payout from a hybrid life policy, or be used to self-fund the risk exposure. And since there is never a payment required for as long as the borrower is living in their home, they can age in place indefinitely which, according to a recent survey by AARP, 77% of all adults would like to do.
Hedging tax risk
While no one can predict the future, we can observe circumstances to arrive at basic conclusions. When it comes to taxes, we know the federal government has large budget deficits, and there are historically low-income tax rates and high estate tax exemption rates. A simple conclusion is that something must give, and more than likely, it will be higher income tax rates and lower estate tax exemption rates, all of which have been discussed in Washington.
The estate tax exemption for 2022 is $12,060,000 per person. After December 31, 2025, that rate will return to the 2016 level of $5 million, adjusted for inflation, without legislative changes. With reverse mortgage loan amounts as high as $4 million, higher net worth consumers could prepare for this change by using the income-tax-free proceeds from the reverse to maximize their gift tax allowances prior to 2026. This can also include gifting to irrevocable life insurance trusts (ILITs), which could be a great strategy to transfer wealth out of a potentially taxable estate.
Roth IRA conversions are another strategy to hedge against income and estate tax risks. However, having the liquidity available to pay the upfront tax bills on the conversion can be daunting. A reverse mortgage line of credit could be the solution as it can be drawn from as needed to pay for the conversion tax bills.
Consider a 62-year-old man with a $750,000 home and $1.3 million in investments, currently in the 22% tax bracket. He can stay in that tax bracket through a series of partial Roth conversions, use a reverse mortgage line of credit to pay the federal taxes, and eventually convert 100% of his retirement assets to a Roth without incurring a monthly principal or interest payment.
The tax advantages to Roth conversions are unique to each situation but can include safeguarding against income and Medicare bracket jumps and Medicare surtax charges.
Another consideration is the impact of retirement distributions on Social Security. With our hypothetical 62-year-old, let’s assume the only other projected retirement income to be approximately $70,000 per year in Social Security benefits for him and his wife. If he is looking to supplement that with $100,000 per year from his retirement savings, he will have zero tax liability if the funds come from a Roth. However, without the conversion, not only will his IRA distribution be taxable, but so too will be 85% of the Social Security benefit.
Risk can be scary. While it can’t be eliminated, it can be managed. Home equity can be a powerful tool to mitigate risk in retirement, and it’s time to explore the potential of this underutilized resource.
Stephen Resch is both a wealth manager and vice president of retirement strategies at reverse mortgage lender Finance of America Reverse LLC. Learn more at www.HomeEquityU.com.
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