Using your 401 (k) to pay off a mortgage

• Reduced retirement savings

• A heavy tax bill

• Loss of mortgage interest deductibility

• Decrease in investment income

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Benefits of discharging your mortgage

Here are the factors in favor of a mortgage-free life in retirement, even if that means using most or all of your 401 (k) balance to do so.

Increase in cash flow

Since a mortgage payment is usually a large monthly expense, eliminating it frees up money for other uses. The specific benefits vary depending on the age of the mortgage holder.

For young investors, eliminating the monthly mortgage payment by tapping into 401 (k) assets frees up money that can be used to meet other financial goals such as funding college expenses for children or purchasing. of a vacation property. With time on their side, young workers also have the optimal ability to replenish the drawdown of retirement savings in a 401 (k) during their working years.

For seniors or couples, paying off the mortgage can swap savings for lower expenses as or when retirement approaches or begins. These reduced expenses may mean that the 401 (k) distribution used to pay off the mortgage does not necessarily need to be replenished before leaving the workforce. Therefore, the benefit of mortgage repayment persists, leaving the individual or couple with less need to earn investment income or retirement assets throughout retirement years.

The excess cash flow resulting from no mortgage payment can also prove beneficial for unforeseen expenses that may arise during retirement, such as medical or long-term care expenses not covered by insurance.

Elimination of interest

Another benefit of withdrawing funds from a 401 (k) to pay off a mortgage balance is a potential reduction in interest payments to a mortgage lender. For a 30-year conventional mortgage on a $ 200,000 house, assuming a fixed interest rate of 5%, the total interest payments equals just over $ 186,000 plus the principal balance. Using 401 (k) funds to prepay a mortgage results in a decrease in the total interest paid to the lender over time.

However, this advantage is strongest if you are barely within the term of your mortgage. If you’re in the middle of paying off the mortgage, you’ve probably already paid most of the interest you owe. This is because the interest repayment is anticipated over the life of the loan. Use a mortgage calculator to see what it might look like.

Estate planning

Additionally, owning a home can be beneficial when structuring an estate plan, making it easier for spouses and heirs to receive assets at their full value, especially when other assets are spent. before death. The asset protection benefits of paying off a mortgage balance can far outweigh the reduction in retirement assets resulting from a 401 (k) withdrawal.

Disadvantages of discharging your mortgage

Against these advantages of paying off your mortgage there are several disadvantages, many of which relate to caveats or weaknesses compared to the advantages we noted above.

Reduced retirement assets

The biggest downside to using 401 (k) funds to eliminate a mortgage balance is the sharp reduction in the total resources you have available during retirement. Of course, your budget needs will be smaller without your monthly mortgage payment, but they will still be significant. Saving for retirement is an overwhelming task for most, even when a 401 (k) is available. Savers must find methods to beat inflation while balancing the risk of pension plan investments.

Contribution limits are in place that cap the total amount that can be saved in any given year, further increasing the challenge.

For 2021, the 401 (k) annual contribution limit is $ 19,500 and for 2022, the limit is $ 20,500. People aged 50 and over can make an additional remedial contribution, which is limited to $ 6,500 each year.

With the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in December 2019, you can now contribute beyond the age of 70 and a half. This is because the law allows plan members to start receiving the minimum required distributions (RMD) at age 72.

Because of these restrictions, a reduction in a 401 (k) balance may be nearly impossible to offset before retirement begins. This is especially true for middle aged or older workers and therefore have a shorter savings trail to replenish their retirement accounts. The increased cash flow that results from running out of mortgage payments can be quickly depleted due to increased savings to fill a pension plan gap.

A heavy tax bill

If you are already retired, there is another type of negative tax implication. Ignoring the tax consequences of paying off a mortgage from a 401 (k) could be a critical mistake. The tax scenario might not be much better if you borrow against your 401 (k) to pay off the mortgage rather than withdrawing the funds from the account.

Withdrawing funds from a 401 (k) can be done through a 401 (k) loan while an employee is still employed by the company offering the plan as a distribution from the account. Taking a loan against a 401 (k) requires repayment through payroll deferrals. However, the loan could have costly tax implications for the account holder if the employee leaves their employer before repaying the loan on their 401 (k).

In this situation, the remaining balance is considered a taxable distribution unless it is paid by the due date of their federal income tax, including extensions. Likewise, employees receiving a distribution of a current or legacy 401 (k) plan must report it as a taxable event if the funds were contributed on a pre-tax basis. For individuals making a withdrawal before the age of 59 and a half, a 10% tax penalty is imposed on the amount received in addition to the income tax owed.

Loss of mortgage interest deductibility

In addition to the tax implications on loans and distributions, homeowners can lose valuable tax savings if they prematurely pay off a mortgage balance. Mortgage interest paid throughout the year is tax deductible for the homeowner. Losing this benefit can result in a substantial difference in tax savings once the mortgage balance is paid in full.

It is true, as we noted earlier, that if you are well advanced in the term of your mortgage, a large part of your monthly payment pays off principal rather than interest, so it is limited in its deductibility. . Nonetheless, homeowners, especially those with limited time for their mortgage, should carefully weigh the tax implications of paying off a mortgage balance with 401 (k) funds before taking out a loan or distribution to do so.

Decrease in investment income

Homeowners should also consider the opportunity cost of paying off a mortgage balance with 401 (k) assets. Retirement savings plans offer a wide range of investment options designed to provide a means of generating returns at a rate above inflation and other cash equivalents. A 401 (k) also provides for compound interest on these returns, as taxes on earnings are deferred until the money is withdrawn during retirement years.

Typically, mortgage interest rates are much lower than what the broader market generates as a return, making a withdrawal to pay off mortgage debt less beneficial in the long term. When funds are withdrawn from a 401 (k) to pay off a mortgage balance, the opportunity to earn money on investments is lost until new funds replenish the 401 (k), if it is. replenished at all.

The bottom line

Keep in mind that you are profiting from the likely appreciation in the value of your home, whether or not you have paid your mortgage. Financially, you might be better off leaving the funds in your 401 (k) and enjoying both their possible appreciation and that of your home.

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