A friend of mine, Tabitha, finalized her divorce last year. Now, the 40-something mother of two was looking at the new year as a healthy restart. After spending the last 15 years raising kids, Tabitha was ready to re-enter the workforce but needed some help on a few financial matters.
In the divorce she received about $500,000 in an Individual Retirement Account. She now needed to find a new home for her 14 and 16-year-old kids.
Having been out of the workforce for quite some time, Tabitha was concerned about qualifying for a mortgage and hoped to take about $250,000 from the IRA to fund a home purchase.
In new situations like this, it rarely makes sense to make large or fast decisions. If it’s a good decision, it will still be a good decision a month or two from now. As such, be as patient, logical and disciplined as possible.
Additionally, jumping to buy a house might not be the wisest decision. Renting a house, duplex or apartment gives far more flexibility. Once you buy a house you have locked up your assets in an illiquid asset with consistent holding costs which are beyond your control.
In a situation like this, it is wise to keep expenses as low as possible until you become comfortable with the budget associated with a “new normal.”
As we discussed this, I pointed out that since Tabitha’s divorce was finalized in 2018, she will file her taxes as Head of Household for 2019. As such, before pulling a chunk out of an IRA, it is always intelligent to evaluate the income tax consequences.
In reviewing the tax brackets, Tabitha needed to understand that if she needs $250,000 from the retirement money, she must pay income tax on it first. As such, she would actually need to pull about $350,000 out to net $250,000. At an approximate average tax rate of 30%, she would lose $100,000 immediately due to income taxes. This is a pretty significant hurdle.Â
Additionally, although real estate has investment components, there are also holding costs beyond an individual’s control. On average, real estate appreciates at about 3.5% per year. That means it doubles in value about every 20 years.
However, a real estate asset also requires a variety of holding costs. Property taxes will run 2.5% to 2.8% annually while insurance will be about 1% per year. Of course, you also need to budget for maintenance. The yard, home owner’s association, air conditioners, plumbers, painters, electricians, etc. are hard to budget for, but all add up over time. Furthermore, many of these items can easily cost thousands of dollars just to get started.
As we discussed this, Tabitha quickly realized the annual cost of property taxes and insurance would offset most, if not all, of the anticipated appreciation. She also admitted she wasn’t too handy with tools or fixing things. As such, she would have to hire help for most of the maintenance.
Tabitha realized the math on her potential property was going backwards.Â
Also, she considered the fact that this would be an illiquid asset. It did not make sense for the single mom to lock up such a large portion of her liquid assets, recognizing that in four years both kids would be out of the house. As such, the need for a big and expensive property will decline.
Conversely, if Tabitha rented, the landlord pays the property tax and insurance. Renters insurance is a fraction of the cost and if the AC breaks or the roof needs replacing, it is typically the landlord’s problem.
Lastly, if Tabitha rented, she had a better opportunity to leave her IRA money invested. As long as it stayed in an IRA it would grow without incurring taxes.
If her $500,000 grows at 7% interest (reasonable over 10-year cycles) after 25 years it will grow to $2.6 million. This would coincide with her planned retirement and greatly help in achieving that goal.
As we finished our conversation, Tabitha realized home ownership was obtainable. However, it was a matter of prioritizing needs and making sure she didn’t back herself into a corner with unexpected expenses while keeping necessary liquidity and flexibility. She also understood that a house makes sense because you need a place to live. However, it needs to be compared to all other investment opportunities.