Pay Off Mortgage With 401K - Empowering Your Financial Journey

Beginning retirement with no debt might sound appealing. Even though some people work part-time during retirement to stay active and supplement other income sources, you’re on a fixed income and it’s unlikely that you will start working again in the years before you pass away.

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

It’s complicated, as with most financial questions, but we’ll outline the benefits and drawbacks so you can decide with greater certainty.

Utilizing 401(k) funds to pay off a mortgage early results in less total interest paid to the lender over time. However, this advantage is strongest if you’re barely into your mortgage term. If you’re instead deep into paying the mortgage off, you’ve likely already paid the bulk of the interest you owe.

Advantages of Withdrawing Retirement Funds for Your Home Loan

Some individuals feel at ease maintaining debt and making monthly payments. But for others, the benefits of eliminating debt are clear.

No More Monthly Payment

By paying off your mortgage loan, you eliminate one of your retirement’s largest monthly expenses. Despite the fact that you’ll still have to pay for healthcare and other costs, having fewer monthly obligations gives you more breathing room and may help you feel less stressed as you get ready for retirement.

A home loan may be for a sizeable sum—well over $100,000—and come with significant interest fees. Debt repayment lessens the financial burden on your resources. Additionally, if your money is in bank accounts or cash-like investments, it’s unlikely that it is earning as much interest as you are paying on the mortgage. Eliminating that debt could result in a tens of thousands of dollars in savings.

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.

There are valid reasons to withdraw funds from your IRA or 401(k) in order to pay off a mortgage, but there are also valid justifications for keeping the funds in retirement accounts.

Potential Pitfalls of Taking Money Out

Review your strategy with your CPA and financial planner before making any decisions. Since every aspect of the decision must be addressed, not all of them are necessarily covered on this page. It might make sense to pay off your mortgage in stages if you’re determined to do so.

A Large Tax Bill (And Other Costs)

When you take money out of pre-tax retirement accounts to pay off a mortgage, you usually incur a hefty tax bill. These expenses might outweigh any advantages you might gain from paying off your mortgage debt. Instead of paying low interest rates in the future, you pay a large tax expense today.

Let’s say you owe $150,000 on your house and you have money you can use to pay it off. For the sake of simplicity, assume that you and your spouse receive $36,000 in Social Security benefits each year and take $36,000 out of your pre-tax retirement accounts each year as 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.

What happens, however, if you take $150,000 out of your IRA to pay off the mortgage?

Your annual income will be significantly higher if you do this:

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 ramifications alone could make the deal unworkable. However, that’s okay because at least now you have an explanation and know why you’re acting the way you are. There might be additional justifications for keeping money in retirement accounts.

However, when you receive distributions from your 401(k), TSP, or other retirement plans, you will still have to pay taxes on those funds. But by withdrawing money gradually, you can control taxes and perhaps avoid some of the aforementioned problems.

If you invest money in your home equity, it might be difficult for you to access those funds in an emergency. For example, suppose you face major medical expenses in retirement. The ability to transfer money quickly into your bank account within a few days is nice to have readily available funds in a retirement account in that situation. However, if the funds are tied to your house, you might have to turn to a reverse mortgage or home equity loan, which can be time-consuming and costly.

In some cases, the money in 401(k), 403(b), 457, and IRA accounts is protected from creditors. Your assets may be more at risk if you withdraw that cash and pay off your mortgage. Despite the fact that state laws may protect your home, certain circumstances may cause you to lose it. To learn about any potential pitfalls, consult a lawyer who is admitted to practice in your state.

Less Money for Spending?

You might have less spending money in retirement if you take withdrawals from your retirement savings. The amount of money you have available will frequently determine how much you can safely spend during your remaining years. Yes, you can use a reverse mortgage to access the equity in your home to generate income, but doing so limits your flexibility and exposes your family to certain risks.

There’s also the question of growth. People frequently mention this when debating whether to invest or pay off your mortgage: the possibility of making more money from investments than you do from interest payments. There are no guarantees, of course, but maintaining your money in investments with a reasonable level of risk may be financially “optimal.” Or maybe not—only time will tell.

FAQ

Is it wise to pay off your mortgage with your 401k?

Paying off your mortgage might be a smart move if the growth potential of your retirement savings is lower than the interest rate on your mortgage. But in addition to the potential tax benefit, pre-tax contributions to your retirement account might provide better growth potential.

Can I use my 401k to pay off my mortgage without penalty?

Typically, a 10% penalty is applied to 401(k) withdrawals made before age 5912. You can avoid this fee by using your 401(k) to purchase a home. However, due to the opportunity cost, some buyers may not be the best candidates for a 401(k) withdrawal for a home purchase.

Should I max out my 401k or pay off my house?

Additionally, starting your retirement savings early will allow you to benefit from compound interest over a longer period of time. In general, you should put your retirement savings ahead of your mortgage the younger you are.