Should we rollover our 401(k) or pay off our mortgage with the funds?
We have a 401(k) with a company that was bought out. It is worth $186,000. We have other investment accounts that total $250,000. We have a rental house that we owe $150,000 on at 3.65% for 25 more years. Should we withdraw from our 401(k) and cash it out with a 10% penalty to pay off the house, or roll it over?
I would not recommend withdrawing from your 401(k), even if you were not subject to the 10% penalty. Don't forget, that in addition to the 10% penalty that is incurred if you are under the age of 59-1/2, you will also pay tax on the amount withdrawn. $150,000 in additional income will most likely throw you into one of the highest tax brackets, so you would pay 28-33%, and possibly more, tax on your distribution. When you add the 10% penalty, you would be paying close to 40% in taxes. Another thing I would mention is that you have a 3.65% mortgage rate, which is extremely low historically. If your investments in your 401(k) can average more than 4% over the years, you are way ahead by staying invested.
Withdrawing money from your retirement plan will increase your income for the year and depending how old you are, may be subject to a 10% penalty. Depending on your level of earned income form your job, you may only wind up with 50% of the money from the 401(k) plan after taxes and penalties to pay that mortgage. It would be a bad idea. If you also consider the long-term return differential on your retirement plan vs. the cost of your mortgage interest rate, it probably would decrease your net worth in retirement because your long-term investment should be out-earning the cost of your mortgage.
Bryan D Beatty, CFP® AIF®
A very good question, to be debt free or continue the investment. It’s personal, and everyone may suggest differently. First of all, it depends on your age. If you still have a long working career, say another 20-30 years before retiring, why pay the gov’t that extra 10% penalty tax? Do you know that is the tax on top of your regular tax? Think another way, how easy or difficult is it for you to get a 10% return? Unless it’s an emergency, it’s better to keep the dough and pay the tax later in retirement. That time will come soon enough.
Secondly, once the money plowed into the house, it becomes illiquid, which means it’s not easy to access without paying some kind of fee. You can certainly ask for a line of credit ahead of the time, but you will be charged with a prevailing rate. Unlike a 401(k), you may be able to borrow from it and pay the interest to yourself. This leads to another idea, rollover to a new 401(k) if your new employment is willing to accept the old one. In my opinion, a 401(k) offers the best asset protection strategy with the least fees. Try that with any trust, you’re looking at inflexibility (not easy to access to your own money) and heavy upfront legal fees.
Definitely a lot to think about, and those two suggestions just get you started. Hopefully you can talk to a professional, such as a CFP®, to dive deep into your situation and offer more personal advice to serve your needs. Best!
Does the rent on the property cover the mortgage payments? Is there any left over?
I do not know your age so I cannot fully answer this question, but paying a 10% penalty to pay off a mortgage with a low interest rate is ot a good idea. In addition to the penalty, you will have to pay taxes on this money also.
Put the money in an IRA and allow it to grow tax deferred until retirement.
If there is extra cash flow from the rental, make extra payments on the house to shorten the maturity on the mortgage.
As long as the payment of the mortgage is not a financial hardship, there is not reason to use retirement monies to pay it down.
Let's look at the withdrawal itself first. Assuming your 401(k) contributions were pre-tax (most are, and all company contributions are), you would not only incur a 10% penalty, but the entire $186,000 will be taxable to you as if it were a paycheck. With no other income, the $186,000 would put you in a 28% tax bracket, which would be about $52,080 in income taxes. The 10% penalty would be $18,600. So out of the $186,000, you would only get $115,320. Assuming you have other income, you could easily wind up in a 33% or higher tax bracket.
Now let's look at the opportunity cost. Paying off the mortgage effectively earns you a 3.65% rate of return. With a diversified stock portfolio, you could expect to earn 6-10% over the long haul (10 years or more). With a diversified portfolio of both stocks and bonds, you could expect to earn 4-8%, depending on the mix.
Ideally, I would want to know your ages, your desired income in retirement, what other assets you have, the timing of your planned retirement, and your risk tolerance before giving a formal recommendation. However, knowing only what I do know, I would roll over the 401(k) assets into your own IRA and not pay off the mortgage.