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Paying Off the Mortgage Can Lower Your Tax Bill

Q.   I'm a blue collar guy who is sometimes overwhelmed by investing. So I am thinking of paying off my home mortgage. I owe $65,000 (the house is worth $125,000) and I have that amount in UPS stock. I'm uncertain about the stock market and the mortgage costs 6 percent.

I have $105,000 in four funds in a 401(k) plan, $250,000 in a whole life policy with a $40,000 cash value, and my wife has $20,000 in her 401(k). We make $110,000 a year, keep our credit cards low, and have a $250 payment on a car note. I'll have a Teamster's pension if the union doesn't go bankrupt. We are 50 years old. What should we do?

---J.E., by email from Dallas, TX

  

A. The real issue here is diversification. You've got 22.4 percent of your $290,000 net worth tied up in your employer's stock. That's not horrible--- but a more prudent portfolio would have less of your future tied to your employer's stock.  

Selling your shares and paying off your mortgage could create a path to greater diversification. It could also your lower current income tax bill.

Let me walk you through the steps.

At $65,000 your mortgage interest provides no tax benefits. The $3,900 of interest and estimated $2,200 of real estate taxes that you pay is well below the $10,000 standard deduction on a joint tax return.

Millions of middle income earners are in the same position. If you sold your UPS stock, however, and paid off the mortgage, you could still take the $10,000 standard deduction. And you'd have the mortgage payment money to use in another way.

If you committed the mortgage payment money to larger 401(k) plan contributions, you'd reduce your income tax bill. Your family is in the 25 percent tax bracket, so every $1 of increased 401(k) commitment would have an effective cost of only 75 cents. That makes paying off the mortgage a good tax move.

Before you do this, it is very important that you check with a tax accountant to make certain you understand the tax implications of selling the shares. If the shares are in your 401(k) plan, you may eventually be eligible for a significant future tax break on net unrealized appreciation of company shares.

  

Q. I have a small business. I am in the process of changing a profit sharing plan to a combined 401k and profit sharing plan. Because my business is small, it is difficult to get low prices for both the administrative fees for plan management and low asset-based fees for fund management. Are there any plans similar to the government's Thrift Savings Plan for small businesses?

I currently use a major mutual fund firm for my funds, but it places real restrictions on fund set-up and management. For instance, no employee sub-accounts--- all funds are pooled.

---J.B., by e-mail from Dallas, TX

  

A. You may be doing exactly the right thing. Research has shown that most corporate defined benefit pension plan portfolios earn an average of 200 basis points (that's 2 percentage points) more than the average return in their employee 401(k) plans. The pension fund advantage is believed to come from two sources. First, it's a lot less expensive to have a single pool of money managed than to manage the record keeping for individual accounts with multiple choices. Second, professional management may do a better job of asset allocation than individuals do.

So you are on the right path--- combine profit sharing with the 401(k) plan so the employees' saving is augmented by profit sharing, and let them know everyone's money will be together in the same closely watched pot. Other research has shown that when employees are given a managed fund option, the majority (up to 70 percent) choose it because they'd rather have someone else make the decisions.

That tells me that the answer for small firms is to have an investment adviser who manages a single pooled fund--- just what you have been doing. They can get your total costs under 100 basis points, right in the ballpark with large employer 401(k) plans.

You have to be a very, very large employer to get in the ring with the federal Thrift Savings Plan. How large? Try Exxon Mobil.

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About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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