Should you use 401k to pay off mortgage

Years ago, by the time most people reached retirement, their home was paid off, which helped them avoid the burden of a mortgage in retirement. If that's not the case for you, you're not alone. Today, the oldest baby boomers (born between 1946 and 1951) are less likely to have paid off their homes than previous generations. 1Another study revealed that 44% of 60- to 70-year-old homeowners are carrying mortgage into retirement, and 32% expect it will take them more than eight years to pay it off. 2Your mortgage is a factor in your retirement income plan and can affect your quality of life. Should I pay off my mortgage after retirement? is an important question for many retirees.

When paying off your mortgage may make sense

There may be good reasons to pay off your mortgage. It can save you thousands of dollars in interest, depending on the current size of your debt, and give you peace of mind that no matter what happens in the future, you own your home outright. Paying off your mortgage may make sense if:

• You have substantial retirement savings, especially if the funds you'd be withdrawing are in a taxable account and are not earning much interest.
• You're downsizing. If you're planning to sell your home for a smaller one, you can apply the equity to your new home, resulting in a modest mortgage or perhaps no mortgage.

Your mortgage is a factor in your retirement income plan and can affect your quality of life.

When paying off your mortgage may not make sense

One argument for not paying off your mortgage is that you may be able to do more with that same money by investing it, assuming your expected returns are higher than what you're paying in interest on the loan. For example, if you get a 6% return on an investment and your mortgage is 5%, you're 1% ahead on your money. However, this strategy only works if you actually invest the money and if the investment produces the returns you're hoping for.

You might also wonder if the tax break you get for deducting mortgage interest is a reason not to pay off your mortgage. The answer is: not necessarily. The Tax Cuts and Jobs Act, effective beginning in 2018, reduced the deductibility of some types of mortgage and home equity debt. But one thing that hasn’t changed is this tax break applies only if you itemize deductions. Consult a tax advisor to see what may make sense for you.

Paying off your mortgage may not be in your best interest if:

• You have to withdraw money from tax-advantaged retirement plans such as your 403(b), 401(k) or IRA. This withdrawal would be considered a distribution by the IRS and could push you into a higher tax bracket.
• Withdrawing the funds puts your retirement savings at risk or forces you to make drastic changes in your lifestyle.

Paying off your mortgage early

Paying off your mortgage doesn't have to be an all or nothing decision. You could also pay a little more each month to pay it off early without forking over a big sum all at once. Some lenders offer a bimonthly payment schedule, resulting in one extra payment per year, which gets you to your payoff faster with less interest. If your lender doesn't offer this option or if they charge a fee for it, you can send in the extra payment on your own. If you receive a large check or unexpected windfall, you can apply those extra funds to your mortgage. If interest rates fall at some point in the future, consider refinancing your mortgage and, if possible, shorten the term of your loan.

What about reverse mortgages?

A reverse mortgage, or "home equity conversion mortgage" (HECM), is a type of home equity loan for people 62 and older that converts a portion of home equity into cash. The lender makes payments to the homeowner, who maintains ownership of the home throughout his or her life. However, there are nuances to reverse mortgages, and the terms and conditions should be considered carefully since they affect your beneficiaries. In addition, because lenders require that you live in the home as your primary residence, you’ll need to repay the loan if you want or need to move.

This material is for informational or educational purposes only and does not constitute fiduciary investment advice under ERISA, a securities recommendation under all securities laws, or an insurance product recommendation under state insurance laws or regulations. This material does not take into account any specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on the investor’s own objectives and circumstances.

By Justin Pritchard, CFP®

Beginning retirement with no debt might sound appealing. After all, you’re on a fixed income, and it’s unlikely that you’ll go back to work and start earning an income in your final years of life (although some people work part-time during retirement to stay engaged and supplement other income sources).

So, does it make sense to use retirement funds to pay off a mortgage loan completely when you stop working? If your only debt is a home loan, it may feel satisfying to wipe the slate clean and simply pay living expenses and taxes.

As with most financial questions, it’s complicated—but we’ll break down the pros and cons here so you’re better prepared to make an informed decision.

It’s crucial to understand the potential tax (and other) costs of cashing out.

Continue reading below, or enjoy the video discussion for this article:

Advantages of Withdrawing Retirement Funds for Your Home Loan

Some people are comfortable with keeping debt and making a monthly payment. But for others, the benefits of eliminating debt are clear.

No More Monthly Payment

By paying off your mortgage loan, you get rid of one of your biggest monthly expenses in retirement. Yes, you’ll still have healthcare expenses and other costs, but reducing your monthly obligations gives you more breathing room and could reduce stress as you prepare for retirement.

Stop Paying Interest

A home loan might be a substantial amount—well over $100,000—that generates meaningful interest charges. By paying down the debt, you reduce the financial drain on your resources. Plus, if your money is sitting in cash-like investments or a bank account, it’s probably not earning as much in interest as you’re paying on the mortgage. You might save tens of thousands of dollars by wiping out that debt.

No Worries About Market Movements

Your willingness to take investment risks may decrease as you approach retirement. That makes sense, and we know that the “sequence of returns” issue makes big losses problematic in the years surrounding your retirement date. You might view a lump sum mortgage payment out of your retirement funds as a “guaranteed” return on the interest costs you avoid going forward.

While there are certainly good reasons to take money from your IRA or 401(k) to pay off a mortgage, there are also reasons for leaving the money in retirement accounts.

Potential Pitfalls of Taking Money Out

Before you decide on anything, review your strategy with your CPA and your financial planner. It’s critical to address all of the details, and this page doesn’t necessarily cover everything involved in the decision. If you have your heart set on getting rid of the mortgage, it might make sense to do it in stages.

A Large Tax Bill (And Other Costs)

When you withdraw funds from pre-tax retirement accounts to pay off a home loan, you typically create a substantial tax bill. Those costs may offset any benefits you get from getting rid of the mortgage debt. You pay a large tax expense today instead of paying modest interest charges in the coming years.

Example: Assume you owe $150,000 on your home, and you have assets available to withdraw. For simplicity, you and a spouse get $36,000 per year in Social Security benefits, and you withdraw $36,000 per year from your pre-tax retirement accounts for income.

In this scenario:

• You’re in the 12% federal income tax bracket (you can get a very rough, oversimplified estimate here).
• You might pay roughly $2,692 in federal income tax.
• You might be able to comfortably pay your mortgage during retirement. 

But what if you withdraw $150,000 from your IRA to pay off the mortgage?

If you do so, your income is substantially higher for the year:

• You’re in the 24% federal income tax bracket (although you don’t pay that on every penny of income).
• You might pay roughly $34,191 in federal income tax—an increase of $31,499.
• You could need to withdraw at least $181,499 to cover the loan balance plus the increase in taxes (and we’re ignoring state income tax).
• More of your Social Security income is taxable, which contributes to the increase above.
• That large withdrawal could also affect your Medicare premiums in a few years, thanks to the IRMAA surcharge. You could pay an additional $600 for one year, for example, but you might not view that as a tax issue.
• If you’re under the age of 59.5, you might pay an additional 10% penalty tax on the amount you withdraw (unless you qualify for an exception). That’s an additional $15,000.

Remember that most of your monthly payment might go to principal if you’re many years into your mortgage loan. An amortization schedule can tell you how much is going toward interest charges, which may help you decide what’s best.

The tax consequences alone might be enough to spoil the deal. But that’s okay—at least you get an answer and you know why you’re doing what you’re doing. There may be other reasons to leave money in your retirement accounts.

Granted, you’ll pay taxes on those funds anyway when you take distributions from your 401(k), TSP, or other retirement plans. But by taking funds out slowly, you can manage taxes and potentially dodge some of the issues above.

Access to Funds

When you put money into your home equity, you may have a hard time accessing those funds in an emergency. For example, suppose you face major medical expenses in retirement. In that case, it’s nice to have easily accessible funds in a retirement account—you can zap the money into your bank account within a few days. But if the money is tied up in your home, you may need to resort to a home equity loan or a reverse mortgage, which can be time consuming and expensive.

Creditor Protection?

Money in 401(k), 403(b), 457, and IRA accounts is often protected from creditors, to some degree. Pulling that money out and paying off your home loan could potentially put your assets at greater risk. State laws might protect your home, but there may be situations that result in you losing the home. Check with an attorney licensed in your state to understand any potential pitfalls.

Less Money for Spending?

Taking withdrawals from your retirement savings may leave you with less spending money in retirement. The amount you can safely spend over your remaining years often depends on how much money you have available. Granted, you can take income from home equity using a reverse mortgage, but you lose a lot of flexibility and your family faces certain risks with that approach.

There’s also the question of growth. When discussing the question of paying off your home versus investing, people often point toward this: the potential to earn more on investments than you pay in interest. There are, of course, no guarantees, but it could be financially “optimal” to keep your money invested with an appropriate level of risk. Or maybe not—only time will tell.

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