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in addition to the 10% penalty that is incurred if you are under the age of 59-1/2, you will also pay tax on the amount withdrawn.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.
It is easy to consider only the 10% early withdrawal penalty when contemplating an early 401(k) distribution, however, what also needs to be considered is the fact that the distribution will increase your gross income which would most likely put you in a higher tax bracket.
For example, assume a married couple (filing taxes jointly) has taxable income of $150,000 in 2017. This would place them in the 25% marginal tax bracket (their taxable income above $75,900 is taxed at the 25% rate). However, cashing out a $186,000 401(k) would increase their taxable income by this amount, putting them in the 33% marginal tax bracket (their taxable income between $153,101 and $233,350 would be taxed at 28% and their taxable income above $233,350 would be taxed at 33%). This means that almost all of their 401(k) distribution would be taxed at a higher rate and about $100,000 of it would be taxed at the 33% rate. So they would be effectively be paying an 18% penalty on about $100,000 of the distribution and a 13% penalty on about $86,000 of it.
The actual numbers will vary for each individual circumstance, but an income increase of this magnitude will no doubt increase the effective tax rate for any middle class American couple.
Assuming you have a fixed rate mortgage, it makes sense to maintain the mortgage on the rental house for the following reasons:
- The mortgage rate is very low from a historical perspective and the interest is tax deductible if you itemize deductions on your tax return. Being able to deduct the interest on your taxes effectively lowers your interest costs.
- Over the next 25 years, we could easily see an average annual inflation rate of 3% or more. This means that your mortgage payment will become increasingly smaller over time in real (inflation-adjusted) terms. This chart shows that your mortgage payment would effectively be cut in half in 25 years. With 5% average annual inflation, which is actually more in line with what I expect, your real mortgage payment would be cut in half in 15 years.
- When done properly, the power of rental real estate as an investment comes from leverage. With a small upfront down payment you are able to generate a net annual income that recoups the initial down payment cost in a few years and then leaves you with an income stream and eventually an asset (home) owned free and clear. When you have a low fixed rate mortgage and tax benefits, this further works to your advantage over time as inflation takes its toll on your mortgage while the house likely maintains its value in inflation-adjusted terms.
Now let us pull this all together. By putting off withdrawals from your 401(k) you can continue to grow that investment tax deferred. (It may also be preferable to do an IRA rollover where you have more flexibility to include some assets, such as natural resource related equities, that will do well in a higher inflation environment.) By maintaining your rental property, you continue the benefits of leverage and letting inflation help you, not hurt you. Overall, you are avoiding unnecessary taxes, maintaining more investable assets to benefit from tax deferred compounding, and benefiting from inflation.
It is common for us to become inpatient and just want to pay off all debts as soon as possible. I can easily relate. It may be helpful, if you haven't already, to lay out a record of all the financial reasons you are renting the home—the income return, the remaining asset, minus the costs. In other words, take the time to define it on paper as an investment potentially returning this much if executed over time in such a manner. Make it as real as possible to you as a separate investment strategy. If necessary, isolate it from your regular financial situation. The more you can isolate it as an investment strategy, the more you will not look at the mortgage as a personal debt that you want to pay off as soon as possible. Doing such things as automating payments, etc. may also be helpful to keep you from thinking about it too much.
If removing the mortgage is still an overwhelming desire, it would be preferable to maintain the 401(k) (or possibly seek enhanced strategies made possible after an IRA rollover) and sell the rental home and get out of the rental business entirely. Most clients I have that have got into renting real estate nonchalantly, end up regretting it due to all the related headaches that come with it. On the other hand, if you are handy with fix ups and can easily get good tenants, then you may very well enjoy it.
Worthwhile investing requires a balance between financials and emotions. In this case, the financials point toward maintaining the 401(k) and mortgage on the rental as long as the emotions are not an overriding factor.
I hope you find these points helpful.
Joshua Hall, ChFC
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.