How to deal with debt on a reduced income

Q: My wife and I were discussing paying off major debt. This would include our mortgage ($100,000), a home improvement loan ($50,000), and a vehicle ($20,000).

The only way we could do this is through my retirement Simplified Employee Pension (SEP). It is currently valued at $876,000. It is aggressively invested, about 80 percent stocks, 20 percent bonds. It is not a Roth, so taxes would have to be paid on whatever I withdraw.

We are both 63, and I am the only one employed (self-employed), making about $65,000 a year. My income has been reduced by half over the last two years, and I am actually withdrawing $2,000 a month from the SEP to take care of bills. But it still is not enough to keep ahead. Our credit card bills are about $300 per month, which we pay off. Eliminating these three monthly bills - the mortgage, home, improvement loan, and the car loan - would cut our expenses by $2,200 a month.

Here's what has me concerned: Our health insurance is increasing to $1,200 a month in January. This past year, I had to withdraw $30,000 from the SEP to pay bills and taxes, not including the $2,000 a month we are already withdrawing.

What do you suggest? I want to work until retirement age (maybe longer), but I am losing ground. - J.L., Dallas

A: That's a heavy-duty withdrawal rate - $54,000 a year from an $876,000 account. It figures to 6 percent, a rate that is not sustainable. Worse, when you need to add high withdrawals to your earned income just to pay the bills at age 63, it's pretty clear that you are on your way to a major financial crisis when you do retire.

So let's take this slow and deal with the really big picture first. The good news is that you have a lot more in savings than most people. Withdraw from your retirement account at 4 percent, and you'll have nearly $3,000 a month to supplement your Social Security income. You'll need to look at the estimates you get from Social Security to see how much you and your wife will receive in benefits. But that number - Social Security plus about $3,000 a month from retirement savings - is about the amount you'll have to spend when you retire. Your Social Security benefits may be close to $30,000, possibly more.

That would make your retirement income about the same as your current $65,000 in work earnings. But it's unlikely that it will be enough to pay the money you need to cover your debt service and your ongoing cost of living.

This suggests that you have a major project ahead of you: lining up your spending tracks to meet your future income tracks. Here is a list of steps you can take:

l Pay off the car loan. It will have the largest impact on cash flow, with the least tax consequences.

l Refinance the home improvement loan into a home equity line of credit. This will reduce the interest rate and eliminate principal repayment for a period of time.

l Alternatively, refinance the first mortgage on a 30-year basis and roll in the home improvement loan. The monthly payment on a $150,000 mortgage for 30 years at 4.5 percent is $760 a month, far less than you are now paying.

l Consider selling the house and moving to a lower-cost house or condo, using your sales proceeds to make certain that your new mortgage debt is less than your current debt.

One of the reasons taking $170,000 - your total major debt - out of your retirement SEP in a lump sum and adding it to your $65,000 of earned income isn't a good idea is that it means you'll pay killer income taxes.

l Questions about personal finance and investments may be sent by email to scott@scottburns.com.