Cash IBonds to Paydown Mortgage

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larmewar
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Cash IBonds to Paydown Mortgage

Post by larmewar »

I'm considering whether to cash IBonds with 1.1 and 1.2% fixed rates to paydown 2.875% mortgage with retirement 3-5 years away. After tax calculations indicate 1.8% inflation is the break-even point. Factoring in lumping of itemized deductions, shifts the break-even inflation to 2.6%.
The Ibonds in question are not part of my investment portfolio. I'll have two pensions, one fully and one partially inflation protected so inflation protection isn't a big concern.

Would appreciate thoughts and opinions.

Lar
lack_ey
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Re: Cash IBonds to Paydown Mortgage

Post by lack_ey »

Do you have any fixed income or cash elsewhere to raid instead?

While in a vacuum it may be okay to pay down the mortgage with I Bonds with those fixed rates, this would be about the last form of assets I would get rid of (ignoring the inconvenience factor of dealing with I Bonds, TreasuryDirect, and any emotional or cash flow considerations of having the mortgage gone).

My reasoning is that when you redeem an I Bond, you only get the current value accrued. The market value of the instrument, were it marketable (it's not), would be higher than that value, as evidenced by 30-year TIPS yielding 1.02% now, with the term/liquidity risk that entails, and the 5-year TIPS also I think up lately and now at a round 0%. This means your other fixed income (that is marketable and thus would command a price in line with other securities) is less valuable than the I Bonds, whether you consider them officially a part of your investment portfolio or not.

Now, if you just want to get rid of them for whatever reason, I don't think anyone could claim this a major mistake or anything really to be fretting about either way. Sounds like you'll be more than fine regardless.
bhsince87
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Re: Cash IBonds to Paydown Mortgage

Post by bhsince87 »

Is the mortgage adjustable or fixed rate?
Time is what we want most, but what we use worst. William Penn
Topic Author
larmewar
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Re: Cash IBonds to Paydown Mortgage

Post by larmewar »

The mortgage is fixed rate. Investments are 52/48 equities and FI. Fixed income is TSP G (36% of FI), individual TIPS (5% of FI), short/intermediate bond funds and FI side of Wellington.

Lar
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Re: Cash IBonds to Paydown Mortgage

Post by #Cruncher »

I would hold on to them, Lar.
larmewar wrote:After tax calculations indicate 1.8% inflation is the break-even point. Factoring in lumping of itemized deductions, shifts the break-even inflation to 2.6%.
How did you calculate this? I get a CPI breakeven increase of 1.4% for the following model case:
  • A $1,000 1.1% fixed rate I bond purchased June 2003 is redeemed June 2015 for $1,535.60 (see this web page), and the after tax proceeds used to pay down the mortgage.
  • Mortgage interest is deducted on the Federal tax return but not on the state return.
  • If the I Bond were not redeemed now, it would be held another 18 years until 2033.
  • Tax on I Bond interest is deferred until redemption.
  • The Federal marginal tax rate is 25% every year for the next 18 years.

Code: Select all

1,535.60 = Value $1,000 I Bond June 2015 
1,401.70 = Net proceeds after tax            = 1535.60 - 535.60 * 25%
  2.156% = annual growth rate after 25% ta   = 2.875% * 75%
2,057.81 = $1,401.70 grows to in 18 years    = 1401.70 * 1.02156 ^ 18
2,410.41 = I Bond pretax growth to breakeven = 1000 + 1057.81 / 75%
  2.537% = I Bond annual growth              = (2410.41 / 1535.60) ^ (1 / 18) - 1
  1.421% = CPI annual increase to breakeven  = 1.02537 / 1.011 - 1
If mortgage interest were also deducted on the state return, the CPI breakeven would be less since I Bonds are exempt from state income tax. On the other hand, if mortgage interest isn't deducted on either the Federal or state returns, the breakeven would be much higher: 2.2% for the above model.
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grabiner
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Re: Cash IBonds to Paydown Mortgage

Post by grabiner »

larmewar wrote:I'm considering whether to cash IBonds with 1.1 and 1.2% fixed rates to paydown 2.875% mortgage with retirement 3-5 years away. After tax calculations indicate 1.8% inflation is the break-even point. Factoring in lumping of itemized deductions, shifts the break-even inflation to 2.6%.
I wouldn't cash these in, because they are earning more than the market rate, and they continue to benefit from tax-deferred growth.

With a 2.875% mortgage rate, I wouldn't pay it down unless I could do so at no tax cost: paying it down rather than adding new investments to a taxable account, using dividends from the taxable account, or selling taxable investments with no capital gain.
Wiki David Grabiner
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larmewar
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Re: Cash IBonds to Paydown Mortgage

Post by larmewar »

Cruncher,

My break even inflation rates are for 5-10 years. If not cashed now, the Ibonds will probably be cashed as part of covering expenses while delaying social security. Your assumption that mortgage interest is fully deductible is not completely correct. I'll alternate between taking the standard deduction and accelerating deductions, resulting in the higher 2.6% inflation for break even.

And if Ibonds are cashed after I pass on, the projected effective marginal tax rate to my wife is 46.25% due to taxation of Social Security.

Lar
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grabiner
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Re: Cash IBonds to Paydown Mortgage

Post by grabiner »

larmewar wrote:And if Ibonds are cashed after I pass on, the projected effective marginal tax rate to my wife is 46.25% due to taxation of Social Security.
This is unlikely under current tax law. There is a relatively small window in the 25% tax bracket in which the maximum 85% of SS isn't already taxable, and the window is getting smaller every year because the SS taxation threshold isn't indexed to inflation. See Taxation of Social Security benefits on the wiki, and look at the versions from previous years; in the example on that page, the 46.25% rate for married couples earning $40,000 in SS is already gone.
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Re: Cash IBonds to Paydown Mortgage

Post by #Cruncher »

larmewar wrote:My break even inflation rates are for 5-10 years.
The breakeven CPI increase rates for 5 or 10 years aren't much different than for 18. Here they are for the case of the June 2003 1.1% fixed rate I Bond and a 25% federal tax rate:

Code: Select all

18 years  10 years   5 years *
--------  --------   -------
   2.2%      2.3%      2.3%     If mortgage interest not deducted at all
   1.4%      1.5%      1.5%     If mortgage interest deducted federal only
larmewar wrote:Your assumption that mortgage interest is fully deductible is not completely correct. I'll alternate between taking the standard deduction and accelerating deductions, resulting in the higher 2.6% inflation for break even.
In that case the breakeven rate should be somewhere between the rates for fully deducted and not deducted all all. Maybe 1.9%; but not 2.6%. What federal tax rate are you assuming, Lar?

* Here are the details for the case where, if it isn't redeemed today to pay down the mortgage, the I Bond would be redeemed in five years:

Code: Select all

Mortgage Interest Deducted
     No           Yes                                           Formulas for "No" Case
  --------      --------                                      --------------------------
  1,535.60      1,535.60    Value $1,000 I Bond 6/1/2015 	
  1,401.70      1,401.70    Net proceeds after tax            = 1535.60 - 535.60 * 25%
  2.875%        2.156%      Mortgage reduction annual growth    (2.156% = 2.875% * 75%)
  1,615.12      1,559.46    $1,401.70 grows to in 5 years     = 1401.70 * 1.02875 ^ 5
  1,820.16      1,745.95    I Bond growth to breakeven        = 1000.00 + 615.12 / 75%
  3.459%        2.601%      I Bond annual growth              = (1820.16 / 1535.60) ^ (1 / 5 ) - 1
  2.333%        1.484%      CPI annual increase to breakeven  = 1.03459 / 1.011 - 1
Topic Author
larmewar
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Re: Cash IBonds to Paydown Mortgage

Post by larmewar »

Cruncher,

After mortgage paydown, for illustration (not actual numbers):

Without lumping itemized deductions
2016:
Itemized deductions 12000
Standard Deduction 12,400, (-$3,100 tax)

2017:
Itemized deductions 12000
Standard Deduction 12,400, (-$3,100 tax)

Lumping itemized deductions, accelerating $3,200 prop taxes and $800 of charitable
2016:
Itemized deductions: 16,000 (-$4,000 tax)
Standard deduction: 12,400

2017:
Itemized deductions: 8,000
Standard deduction: 12,400 (-3,100 tax)

So with these numbers there is an additional $900 in tax savings.

Lar
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