Money Watch: Is using 401k to pay off mortgage a good idea? (USA Today Article)

Below is the text from an article in the USA Today… it’s a great question and is not that easy to answer. Whether you should do this or not, depends on your age, your mortgage interest rate, your marginal tax rate, and many other factors. If this is something you are considering, consult a tax professional to evaluate your specific situation.

Q: I will be 59½ in August. I would like to withdraw about $56,000 from my 401(k) savings of $380,000 to pay for my home mortgage as well as to pay for the 20% tax. The pay-off would save me over $4,500 from the 4.75% interest rate. And I will use my mortgage payment for the 401(k) catch-up contribution. Should I do that or just stay the course?

A: By cashing in part of your 401(k) in order to pay off your mortgage you’re trading off a reduced retirement account for lower future loan expenses. To determine whether this makes sense for you consider these factors:

• What is the cost of withdrawing from your retirement account?

Assuming your contributions were all pretax, your withdrawal will be taxed as ordinary income at the federal, state and local rates.

You’ve estimated your tax rate will be 20%, but individuals with higher incomes and local taxes could owe 40% or more on a retirement distribution. Anyone under 59½ must add a 10% penalty to that tax bill.

• Will you be able to rebuild your retirement portfolio?

You’re considering a significant reduction in your future standard of living, especially if the 401(k) is your only pool of funds for retirement. Repaying such a large sum may not be possible at this stage of your life.

If you plan to retire at age 65 you’ll have fewer than six years to pay yourself back. Will you save enough on mortgage payments to make this work?

And will you have the discipline to direct all of the extra savings to your retirement plan? If you think you might spend all or some of the mortgage money, it is better to pass on paying it off.

• What is the real cost of your mortgage?

Even with the recession we’ve just been through the S&P 500 has averaged 4% returns over the past 10 years; over the past three years the average annual return has been over 16%.

Is your 401(k) invested in a portfolio that you expect to return more than the cost of your mortgage over its remaining years? If so, you may again be better off staying the course.

• Do you have other, more costly debt you should pay off first?

Credit card interest rates are typically much higher than mortgage rates. Withdrawing from your retirement plan to pay credit card debt is a bad idea, but paying it down with any extra cash you get your hands on should be your highest priority.

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