Photo of a couple who have considered housing costs as part of their retirement budget planning.

How to account for taxes in your retirement housing plan

Housing costs are the No. 1 budget item for retirees.1 That makes where you’ll live (and how you’ll pay for it) a major decision for retirement budget planning.

“Expense management gets even more important when you start planning how you’ll live on a fixed income,” says Kevin Hansen, director of retirement solutions for Principal®. “You’ll naturally start thinking about paying off the mortgage, so you don’t carry that monthly expense. Or if you should downsize to a smaller mortgage that’s easier to manage.”

Graphic stating that on average, housing accounts for 44% of a retiree’s spending/budget.

There are good reasons to pay off your mortgage before retirement, including simplifying your finances and boosting your cash flow. In general, the less debt you carry into retirement, the better off you are. Plus, there’s the sense of security that comes with knowing you own your home outright.

But there are also reasons to keep your mortgage in retirement, such as certain tax advantages, or keeping your savings bulked up.

Here are four considerations when planning for retirement housing, so you aren’t hit with tax surprises.

1. The mortgage tax break is valuable, but it can be less so in retirement.

The mortgage interest deduction is most valuable for high-income filers who itemize their tax return, since a higher tax rate means you can deduct a higher percentage of taxable income. As retirees are often in a lower tax bracket than when they were working (because they’re not earning as much income), the value of the mortgage interest deduction is also lower.

That said, fewer people are itemizing their tax returns since tax laws changed in 2018, increasing the standard deduction.

“Under the current tax law, a lot of people aren’t getting a tax deduction benefit for paying interest on their mortgage, because they’re just claiming the standard deduction,” says Principal counsel Jared Yepsen.

That’s especially true for many retirees. If you’ve been in your home for a long time, you may be well into the amortization of your mortgage, meaning you’re paying more in principal than interest.

Retirees who’ve recently moved have often downsized, meaning a smaller mortgage and lower interest payments.

2. Paying off your mortgage with retirement funds could trigger a tax bill.

Thinking about paying off your mortgage with pre-tax retirement funds like your 401(k) or IRA? You’ll owe ordinary income taxes on that cash. If you take out a large amount it could push you into a higher income tax bracket for the year. If you’re pre-retirement age (usually under 59.5), you could also owe a 10% penalty for making an early withdrawal.

Learn more: “Should I use my 401(k) to pay off my mortgage? 5 things to consider

3. Mortgage or not, you’ll still have to pay property taxes.

After decades of paying your mortgage every month, it’s easy to forget that for many homeowners that payment also includes property taxes that your lender is holding in escrow on your behalf. If you do eliminate your mortgage, you may be surprised at how much you still owe every year in property taxes.

“Those property taxes aren’t going to go away,” Hansen says. “That has to be part of any consideration about managing your housing expenses in retirement.”

So factor those into your retirement budget. If your current payments seem unsustainable over the long term—or you’re just ready to downsize—it might make sense to move to an area with lower property taxes.

4. If you’re selling your house for retirement, you might owe capital gains taxes.

Selling a home that’s increased in value over time can be a great way to boost your nest egg (or pay for your dream house in retirement). But you may have to pay capital gains taxes on the profit you’ve made.

The good news: The IRS has relatively high thresholds before this tax kicks in. Single filers can keep the first $250,000 in real estate gains before they owe taxes, and married couples filing jointly can keep the first $500,000.

There are a few exceptions to this rule. You may still owe the capital gains real estate tax if you didn’t own and use the home as your primary residence for at least two of the previous five years. And you can only use this exclusion once every two years.

Taxes can get complicated, so if you’re concerned with the tax impact of your housing plan on retirement, consider meeting with a tax professional.

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1 EBRI Issue Brief: Older Americans’ Spending Profiles, December 2020.

* Individual circumstances and tax deductions will vary based on the individual, their tax bracket, and other factors. The example is for illustration purposes only. It is intended to be educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment, or tax advice. You should consult with appropriate counsel, financial professional, or other advisors on all matters pertaining to legal, tax, investment, or accounting obligations and requirements.

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other financial professional on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Securities offered through Principal Securities, Inc., 800-547-7754, member SIPC and/or independent broker-dealers. Principal Life, and Principal Securities are members of the Principal Financial Group®, Des Moines, Iowa 50392.