Using Your 401(k) to Pay Off a Mortgage

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Using Your 401(k) to Pay Off a Mortgage

As you prepare for retirement, you may have the following questions. Is it prudent to put money aside in a 401(k) or other employer-sponsored retirement plan while still paying a sizable monthly mortgage? Could using current retirement funds to pay off the mortgage be preferable in the long run? By doing so, you may significantly lower your monthly costs before you quit your job and your steady income.

Key Takeaways

  • As retirement nears, paying off a mortgage using money from your 401(k) might lower your monthly payments.
  • If you pay off your mortgage early in the duration of the loan, you may also be able to cease paying interest.
  • Reduced retirement assets and a greater tax burden in the year that the money is taken from the 401(k) are two major drawbacks of the move (k).
  • Additionally, if the money stays in your retirement account, you won’t get the tax-advantaged investment returns that you would have received.

Regarding the question of whether it is wise to pay off your mortgage before retiring, there is no one right answer. The advantages depend on your financial situation and priority settings. Here is a breakdown of the move’s benefits and (compelling) drawbacks to assist you in determining if it could be a good idea for you.

Pros
  • Increased cash flow

  • Elimination of interest

  • Estate-planning benefits

Cons
  • Reduced retirement assets

  • A hefty tax bill

  • Loss of mortgage-interest deductibility

  • Decreased investment earnings

Pros to Discharging Your Mortgage

Here are several reasons to consider living mortgage-free in retirement, even if doing so requires spending most or all of your 401(k) balance.

Increased Cash Flow

Eliminating a mortgage payment frees up money for other purposes as it is often a sizable monthly cost. Depending on the age of the mortgage holder, different perks apply.

Younger investors may achieve other financial goals, such as paying for their children’s education bills or buying a vacation home, by removing the monthly mortgage payment by using their 401(k) funds. Younger people also have the best chance of recouping the depletion of retirement funds in a 401(k) throughout the course of their working years since time is on their side.

Paying off the mortgage might exchange money for fewer costs when retirement draws near or starts for older people or couples. The 401(k) contribution used to pay down the mortgage may not need to be replaced before leaving the employment due to the decreased costs. As a result, the advantage of paying down the mortgage continues, reducing the requirement for the person or couple to draw income from investments or retirement savings throughout their retirement years.

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If you don’t have a mortgage payment, you may be able to use the extra money you have for unforeseen retirement needs like uninsured medical or long-term care fees.

Elimination of Interest

A possible decrease in interest payments to a mortgage lender is another benefit of taking money out of a 401(k) to pay down a mortgage amount. The total interest payments, in addition to the principle amount, for a standard 30-year mortgage on a $200,000 property, assuming a 5% fixed interest rate, come to somewhat more than $186,000 per year. A mortgage that is paid off early using 401(k) savings results in less interest overall being paid to the lender over time.

The strength of this benefit depends on how far along in your mortgage term you are. If, however, you’re far along the way to paying off the mortgage, you’ve probably already covered the majority of the interest you owe. Because interest is front-loaded throughout the course of the loan, this is the case. If you want to see how this would work, use a mortgage calculator.

Estate Planning

Owning a house entirely may also be advantageous when constructing an estate plan since it makes it simpler for spouses and heirs to acquire property at full value, particularly when other assets are depleted prior to death. Paying down a mortgage amount might help secure your assets, which may exceed the loss of retirement funds caused by a 401(k) withdrawal.

Cons to Discharging Your Mortgage

There are a number of disadvantages to paying off your mortgage, many of which are connected to restrictions or limitations on the benefits we previously mentioned.

Reduced Retirement Assets

The biggest drawback of paying down a mortgage amount using 401(k) earnings is the drastic decrease in overall resources available to you in retirement. Your financial demands will still be substantial even if they will be more modest without your monthly mortgage payment. Even with the availability of a 401(k), most people find saving for retirement to be an onerous chore. Savings must be done while managing the risk involved with retirement plan investments.

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The difficulty is further increased by contribution caps that impose a ceiling on the total amount that may be saved in any one year.

The 401(k) yearly contribution cap is $19,500 for 2021 and $20,500 for 2022. An extra catch-up payment of up to $6,500 may be made by those 50 and older each year.

You may now make contributions after turning 70 12 thanks to the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was passed in December 2019. Because of this, plan members may start receiving required minimum distributions (RMDs) at age 72 under the act.

These limitations make it practically hard to make up a decrease in a 401(k) balance before retirement starts. This is particularly true for those who are middle-aged or older and who therefore have a shorter savings runway to fund their retirement funds. Due to increasing savings to cover a retirement plan shortfall, the additional cash flow that results from having no mortgage payment may be rapidly drained.

A Hefty Tax Bill

There are various negative tax implications if you are already retired. It might be a serious error to ignore the tax repercussions of paying off a mortgage using a 401(k). If you borrow money from your 401(k) to pay down the mortgage rather than taking cash out of the account, the tax situation may not be all that much better.

While a person is still working with the employer sponsoring the plan, a distribution from the account may be made by taking out a 401(k) loan. Loans against 401(k)s must be repaid via payroll deductions. But if the individual quits their job before paying back the loan against their 401(k), the account owner may incur expensive tax consequences (k).

Unless it is paid up by the due date of their federal income tax, including extensions, the balance in this case is regarded as a taxable distribution. Similarly, if pretax contributions were made, workers must record distributions from current or prior 401(k) plans as taxable events. A 10% penalty tax is added to the amount obtained for anyone who withdraw money before turning 5912 in addition to the income tax that must be paid.

The Loss of Mortgage-Interest Deductibility

Along with possible tax repercussions for loans and dividends, homeowners risk losing out on significant tax breaks when they pay off their mortgage sum early. The homeowner is able to deduct whatever mortgage interest they pay during the year. Once a mortgage debt is paid off in full, the loss of this advantage might result in a sizable difference in the amount of tax savings.

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It is true, as we said before, that if you are far into the term of your mortgage, a large portion of your monthly payment goes toward principle rather than toward interest, thus its deductibility is constrained. However, before accepting a loan or distribution to do so, homeowners—especially those with little remaining on their mortgage term—should carefully consider the tax ramifications of paying down a mortgage amount using 401(k) earnings.

Decreased Investment Earnings

Homeowners should also think about the potential cost of using 401(k) assets to pay down a mortgage amount. A variety of investment alternatives are available via retirement savings programs, all of which are designed to provide returns that are higher than those of inflation and other cash equivalent assets. Compound interest is also offered by a 401(k) on those returns since taxes on gains are postponed until the money is taken after retirement.

A withdrawal to pay off mortgage debt is often less favorable over the long run since mortgage interest rates are typically much lower than the return generated by the wider market. When money is taken out of a 401(k) to pay off a mortgage obligation, the potential to profit from the investments is lost until the 401(k), if it is ever replaced, is refilled with fresh money.

The Bottom Line

Remember that whether or not you’ve paid off your home’s mortgage, you still get to enjoy the inevitable increase in value. Overall, it could be more financially advantageous for you to keep the money in your 401(k) and take advantage of both its potential growth and the value of your property.

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