Using your 401(k) is not generally the best way to pay off your house. But if you’re thinking of going in that direction, you’ll have to know what the pros and cons are of using your retirement money to pay off your mortgage, along with the steps you should take to do it.
Here are the things you should factor into your decision, along with consequences you won’t want to overlook.
The main benefit to using your 401(k) to pay off your house is that you’ll no longer have to worry about making mortgage payments. If you’re like most American households, this will provide a significant boost to your monthly cash flow, possibly in the thousands of dollars. You’ll also avoid paying potentially tens of thousands of dollars in interest over the life of your mortgage. This alone could make the idea of paying off your home early make sense.
Another factor that many overlook when it comes to paying off your mortgage is that it can make the transfer of wealth to your heirs easier and less costly. If you pass on a 401(k) to your heirs, all of the money in the account becomes taxable as your heirs withdraw it. But in a house, your money can potentially pass to your heirs tax-free. This is because upon your death, the cost basis in your house “steps up” to the current market valuation. If your heirs sell the house, they will likely pay only small or even nonexistent capital gains. That could amount to tax savings of tens or even hundreds of thousands of dollars for your beneficiaries.
In most cases, taking money out of your 401(k) plan to pay off your mortgage is a bad idea. From just a strictly mathematical perspective, it’s highly likely that you’re earning more in your 401(k) plan than you are paying in interest on your mortgage. Even if you have a relatively conservative 401(k) allocation, for example, you’re likely earning at least 5% on your money. Considering that most existing mortgages are costing homeowners less than 5%, the math doesn’t make sense.
Another huge drawback is that you’ll owe ordinary income tax on any money you withdraw from your 401(k). If you’re in a high tax bracket, the combined hit to your nest egg can approach 50%, meaning your $100,000 withdrawal to pay off your mortgage is really only worth $50,000.
The last significant drawback to paying off your mortgage this way is that it will wreak havoc on your retirement savings plan. When you take money out of your 401(k), you not only lose the actual amount you withdraw, you also miss out on its future growth. If you take $100,000 out of your 401(k) at age 40, for example, you’ll be missing out on 25 years of growth, assuming you plan to retire at 65. At even just a 6% annual rate of return, that money could have grown to nearly $450,000 by age 65. If you’re looking to analyze the real damage that a withdrawal can cause to your retirement plan, look at the total amount you’ll be losing in the future, not just the amount you’re planning to withdraw today.
Bottom Line: Dos and Don’ts
If you’re considering drawing down your 401(k) plan to pay off your house, keep these do’s and don’ts in mind:
- Compare the interest rate you’re earning in your 401(k) with the rate you’re paying on your mortgage
- Have a plan for what to do with the excess cash flow if you pay off your home
- Factor in the tax ramifications of withdrawing from your 401(k), including any penalties
- Replace the money you withdrew from your 401(k) plan as rapidly as possible by maxing out your contributions
- Fritter away the extra money in your monthly budget after paying off your mortgage
- Pay off your home with your retirement money if you have a low-rate mortgage
- Decimate your nest egg if you have no plan to restore it
- Forget that the real amount you’re withdrawing from your 401(k) should include potential future gains as well
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