Paying off your mortgage provides peace of mind, but requires careful analysis. This type of payoff may not be your best financial choice, depending on how you generate the cash required for the payoff. Whether you have the money in hand due to the good luck of a windfall or the bad luck of a lump sum payout as part of your severance package, review the tax impact of paying off your mortgage.
Losing a Tax Break on Income Taxes
Your mortgage provides a break on your taxes. In most cases, you may deduct the entire amount of interest you pay on your mortgage when filing your income tax return by filling out Schedule A of Form 1040. By paying off your mortgage, you lose this tax break. However, the amount of this deduction may not be significant, depending on your tax bracket, mortgage amount and interest rate. Run the numbers to see whether the mortgage interest deduction has significant value given your tax picture. Also, compare the tax benefit connected with keeping the mortgage to the advantage of not paying monthly principal and interest over the remaining life of the loan.
Still Pay Property Taxes
Paying off your mortgage doesn't remove your property tax obligation. This annual obligation, typically paid in two installments, is the amount owed to your local government based on the value of your home, not your mortgage value. While paying property taxes impacts your annual filing with the IRS, paying off your mortgage has no impact on your property tax obligation.
Danger of Lump Sum Early Distribution
Do not use your retirement savings to pay off your mortgage unless you're in danger of losing your house. While this lump sum may be tempting if you've lost your job or are worried about your monthly budget, especially with retirement so far away, it's best left alone. The tax consequences are significant. Not only do you pay normal income tax on what you withdraw, you also lose 10 percent of the sum as a penalty for taking funds from your retirement before you reach retirement age. In addition, you lose the interest you would earn over the life of your investment.
If you've lost your job, and your employer provides a lump sum payout for salary, vacation and commission, hold off on using the funds to pay off your mortgage. You may need the money for taxes. The lump sum is counted as ordinary income on your income tax return, which your employer takes out prior to issuing you a check. However, it may inflate your earnings if you move immediately into another job, or if the lump sum moves you into a higher tax bracket. This may mean you need to make quarterly payments, or pay an underpayment penalty. If you sink the funds into a mortgage payoff, you won't have the cash to make the tax payments required.
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