For most individuals, a retirement savings plan through work, such as a 401(k) plan, represents one of the most powerful benefits made available by employers. The combination of personal contributions and employer matching (if you get it) provides individuals with the opportunity to set aside savings for the long term in a tax-advantaged way. Employer-sponsored plans also offer an array of investment options, including stocks, bonds and cash equivalents that not only allow for diversification but also have the potential to generate higher returns than conventional savings accounts or certificates of deposit (CDs), especially in a low interest rate market. While there is no guarantee on the performance of investments held within a 401(k) plan, the marriage between tax deferral and long-term capital appreciation proves beneficial when saving toward retirement.
One of the greatest hurdles when creating an effective retirement plan is determining how much an individual or couple needs to set aside to be able to draw income in an effort to maintain a comfortable lifestyle throughout retirement. Among the considerations are the amount of assets a person has at the time he retires, which required expenses remain, and which expenses increase or decrease. With retirement income or distribution planning, a common question asked by pre-retirees is whether 401(k) assets should be used to pay down a remaining mortgage balance prior to leaving the workforce to reduce monthly expenses.
While there is no single answer to this question that suits every individual best, there are pros and cons to withdrawing funds from retirement savings plans to pay down a mortgage. The most common advantages to using 401(k) assets to pay off a mortgage include freed-up cash for other living expenses, elimination of interest payments to the lender and increased asset protection. The drawbacks to an early payoff by way of a 401(k) distribution include reduced retirement savings, tax implications and a decreased rate of return.
Because a mortgage payment represents a substantial amount of cash outflow each month, paying off a remaining mortgage balance is beneficial to individuals hoping to reduce budgetary restrictions prior to or in retirement. For younger investors, eliminating the monthly mortgage payment with 401(k) assets frees up cash that can be used to meet other financial objectives, such as funding college expenses for children or purchasing a vacation property. With time on their side, younger workers also have the ability to replenish the drawdown of retirement savings in a 401(k) over the course of their working years.
For older individuals or couples, 401(k) account balances represent a substantial portion of total assets and, as such, a distribution from a retirement savings plan may not need to be replenished prior to leaving the workforce. This means the freed-up cash from a mortgage payoff carries over into retirement years, leaving the individual or couple with a smaller need to draw income from investment or retirement assets throughout the retirement years. The excess cash from not having a mortgage payment may also prove beneficial for unexpected expenses that could arise during retirement, such as medical or long-term care costs not covered by insurance.
Elimination of Interest
Another advantage of withdrawing funds from a 401(k) to pay down a mortgage balance is the elimination of interest payments to a mortgage lender. Over the course of a conventional 30-year mortgage on a $200,000 home, total interest payments equal slightly more than $186,000 in addition to the principal balance, assuming a 5% fixed interest rate. Utilizing funds from a 401(k) to pay off a mortgage early results in less total interest paid to the lender over time.
However, be aware that if you are deep into your mortgage, you may have already paid the bulk of the interest you owe. Carefully calculate how much interest paying off your mortgage will actually save.
"Just because you are 10 years into a 20-year mortgage for $300,000 doesn't mean you now owe the bank $150,000," says Simon Brady, a fee-only certified financial planner at Anglia Advisors in New York City. "Mortgages don't work in a linear fashion like that. You have spent the last 10 years predominantly paying interest and still owe principal that is going be considerably more than half what the original loan was for. The 10 years that lie ahead of you comprise paying down more and more principal and less and less interest with each payment. You've already done much of the heavy lifting regarding interest payments – and if you suddenly give the bank the principal owed now, the effective interest rate that you will have paid over the now-10-year life of that mortgage would probably shock you if you calculated it."
Withdrawing funds from a 401(k) to pay off a mortgage balance also proves beneficial for asset-protection planning. In most states, the equity built up in a home is protected from lawsuits and other legal proceedings when no lien or mortgage exists on the property.
Additionally, owning a home outright can be beneficial when structuring an estate plan, making it easier for spouses and heirs to receive property at full value, especially when other assets are spent down prior to death. The asset-protection benefits of paying down a mortgage balance may far outweigh the reduction in retirement assets from a 401(k) withdrawal.
Retirement Savings Reduction
While benefits for mortgage payoff exist, utilizing a 401(k) to do so is not always the best option for individuals or couples. The greatest caveat to using 401(k) funds to eliminate a mortgage balance is the stark reduction in total retirement assets. Saving toward retirement is an overwhelming task for most, even when a 401(k) is available. Savers must find methods to outpace inflation while balancing the risk of retirement plan investments, and contribution limits are in place that cap the total amount that can be saved in any given year.
Due to these restrictions, a reduction in a 401(k) balance may be near impossible to make up before retirement begins. The cash flow increase resulting from no longer having a mortgage payment may be quickly depleted due to increased saving to make up a retirement plan deficit.
And don't forget, as Cary Carbonaro, managing director of United Capital of New York & New Jersey in Huntington, N.Y., points out: "Your 401(k) is a protected investment." Money in a 401(k) is protected by federal law from most types of creditor judgments including bankruptcy (though not the IRS or possibly spousal/child support orders). You might be better using another source of funds to pay down a mortgage, if that's an option.
Withdrawing funds from a 401(k) can be done through a 401(k) loan while an employee is still employed with the company offering the plan or as a distribution from the account. Taking a loan against a 401(k) not only requires repayment through paycheck deferrals but may also result in costly tax implications for the account owner. If an employee leaves his employer before repaying the loan against his 401(k), the remaining balance is considered a taxable distribution. Similarly, employees taking a distribution from a current or former 401(k) plan must report it as a taxable event if the funds were contributed on a pretax basis. For individuals making a withdrawal prior to age 59½, a penalty tax of 10% is assessed on the amount received in addition to the income tax due.
If you're already retired, there is a different kind of negative tax implication: "Paying off their mortgage from a 401(k) is one of the biggest mistakes I see retirees make," says Jonathan Swanburg, an investment advisor representative at Tri-Star Advisors in Houston. "They tend to overlook the tax consequences. Any money taken out of the 401(k) is counted as ordinary income. Taking out a large sum to pay off something like a mortgage (especially during a year when the retiree still has earned income) can easily step a person into a higher marginal tax bracket. On a $100,000 distribution, stepping from what could have been a 15% bracket to a 25% bracket would cost the person $10,000 in extra taxes – $13,000 if they step into the 28%. I’ve seen some people step themselves all the way up to 39.6%."
In addition to tax implications for loans and distributions, homeowners may lose valuable tax savings when paying off a mortgage balance early. Mortgage interest paid throughout the year is tax-deductible to the homeowner, and the loss of this benefit may result in a substantial difference in tax savings once a mortgage balance is paid in full. Homeowners should carefully weigh the tax implications of paying off a mortgage balance with 401(k) funds prior to taking a loan or distribution.
Decreased Rate of Return
Homeowners should also consider the opportunity cost related to paying off a mortgage balance with 401(k) assets. Retirement savings plans offer a wide array of investment options meant to provide a way in which returns are generated at a greater rate than inflation and other cash equivalent securities. A 401(k) also provides for compound interest on those returns because taxes on gains are deferred until the money is withdrawn during retirement years.
Typically, mortgage interest rates are far lower than what the broad market generates as a return, making a withdrawal to pay down mortgage debt less advantageous over the long term. When funds are taken out of a 401(k) to pay off a mortgage balance, the investment opportunity on these assets is lost until they are replenished, if they are replenished at all.