What Happens If I Pay Off My Home Early?

As a tax professional, this question is often asked by my clients. With the passing of the Tax Cuts and Jobs Act of 2017 and the first major overhaul to our tax code since 1986, I thought it might be helpful to take a new look at this old question.

One of the first things to consider when looking at paying off your home is where will the money to pay your home off be coming from.  In tax and financial speak there are two major types of assets: those that are considered pre-tax and those that are considered post-tax.  Pre-tax money, which is also known as “qualified“ or “before tax” money, would be funds on which you have not paid taxes on yet but will when you take a distribution.  The most common sources of pre-tax funds would be assets held inside 401(k)s, 403(b)s, 457(b) retirement plans and deductible traditional IRAs.  Post-tax money, also known as “non-qualified” or “after tax” money, are funds which you have likely already paid taxes on in part or in full. A few examples of post-tax funds would be checking accounts, savings accounts and investment brokerage accounts.  If you are pulling money from a post-tax source it will likely have less of an impact on your tax return or no impact at all.  If you are taking funds from a pre-tax source then it will definitely have a negative effect on your tax return because you will owe taxes on those funds you distribute.

Now that we have touched on where your money will be coming from we can look at the question of whether my home was helping me on my tax return as a deduction.  The tax law provides everyone regardless of filing status a standard deduction.  Here are the standard deductions for the previous 2 years and for the 2018 tax year:

Filing Status                      2016                        2017                      2018               

Married Filing Joint           $12,600                     $12,700                    $24,000

Head of Household           $9,300                       $9,350                     $18,000

Single                                 $6,300                       $6,350                     $12,000

If your itemized deductions do not exceed the above amounts for your filing status then you do not itemize on your return and instead use the standard deduction.  The itemized deduction form is called Schedule A and the 3 big items on that schedule are mortgage interest, property taxes and charitable contributions.  So if you don’t see a schedule A in your copy of your most recently filed return then chances are paying off your home would not reduce your deductions at all on your tax return moving forward since you are using the standard deduction.  If you are in this situation there are a few considerations you need to be aware. First, is if the money to pay the house off is coming from a pre-tax or post-tax source and the tax ramifications mentioned in the discussion above. Secondly, how much money will you need to pay off the loan?  Again, if pulling from post-tax source you will likely need to pull out less in comparison to a pre-tax source since you will owe taxes if the monies are coming from pre-tax funds.  Lastly, you will want to know the interest rate on the loan you are paying off in comparison with potential additional tax you may incur to distribute the funds to pay the home off.  If you pull out a large sum of money from a pre-tax account you are likely to push your income up into a higher tax bracket and actually end up paying more in tax on the money you distributed than interest you saved by paying off your loan!

If you do make a schedule A because your mortgage interest, property taxes (which will be capped at $10,000 max beginning in 2018) and charitable contributions exceed the above standard deductions then you will be reducing your deductions and likely owe more tax on a return as a result of paying off your home.  This does not mean that you should not pay off the home because there is the possibility that the money you would be saving in interest could exceed the value of the deduction on the tax return.  With the almost doubling of the standard deduction for each filing status from 2017 to 2018 the scales have heavily tipped in favor of paying off your home.

Just a final thought… It is difficult to put a price on peace of mind. If I were to suddenly come in to enough money to pay of my home, you would be hard pressed to convince me not to do it even if it was financially advantageous to continue to pay to get the deduction.  As you can see, there are a lot to consider when thinking about paying off your home and you should always consult a tax professional before making any decisions.

Joe Webb
Senior Tax Professional