Pay off a mortgage with 401 (k) funds? Almost always a bad idea
Are you thinking about withdrawing money from your 401 (k) to pay off a mortgage?
Think carefully before you do it. Because this will cost you a lot of money in the long run.
Immersion in your 401 (k) is rarely required. There are many ways to repay your mortgage early without touching the money you have saved for retirement.
We'll cover these below. But first, here's what you need to know about using your 401 (k) to pay off a mortgage.
Check your eligibility for a shorter term mortgage (October 27, 2020).
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Dangers of Using Your 401 (k) to Pay Off a Mortgage
The main reason not to use your 401 (k) to pay off a mortgage is that it steals money away from your nest egg in retirement.
Not only do you remove a lump sum from your retirement account, but you also lose years of accrued interest on that money.
Say you are 35 years after you retire. If your 401 (k) pays around 10 percent interest, the money you take out could potentially have doubled three to five times.
The returns you miss out on are much higher than the amount originally withdrawn.
401 (k) withdrawal penalties are severe
Aside from your depleted retirement assets, there is a more immediate financial impact when you withdraw funds from your 401 (k). (At least if you are younger than 59½ years.)
These penalties apply to 401 (k) withdrawals rather than 401 (k) loans.
Typically, those who fail 59½ will have to pay a 10 percent penalty which will be deducted from their 401 (k). This is a $ 100 fee for every $ 1,000.
There is also a tax rate during the year the payout is made.
Each penny withdrawn would be taxed at the individual's normal rate in the same year. The additional “income” could even drive them into a higher tax band.
If you add these taxes to the 10 percent penalty, you lose between 30 percent and half of the funds you raised.
Withdraw 401 (k) funds if you are over 59½ years old
Once you have passed the magical age of 59½, you no longer have to pay a 10 percent fine for withdrawing funds.
However, the tax implications remain the same.
When the Washington Post addressed this exact issue in 2019, it consulted Julie Welch, a CPA and personal finance planner in Leawood, Kansas. She said:
“While you would not receive a penalty for early redistribution of funds from an IRA or 401 (k) because you are over 59½ years old, any distributions you make to pay off a mortgage would be income and taxable for you. ”
The case against (and for) using 401 (k) funds to pay off a mortgage
It is true that there are two schools of thought here.
Some money experts like Dave Ramsey say you should never touch your 401 (k) to pay off a mortgage – unless the only alternative is bankruptcy or foreclosure.
We agree that using your 401 (k) to pay off a mortgage is almost never the right step.
However, the Boston University economist wrote in Forbes in April 2020 Laurence Kotlikoff made the opposite case.
To give you a fair overview of both perspectives, we've outlined the arguments for and against using a 401 (k) to pay off a mortgage below.
Why Using a 401 (k) to Pay Off a Mortgage is a Bad Idea
Dave Ramsey's website highlights the dangers of withdrawing your 401 (k) to pay off a mortgage.
There is an example of someone aged 45 with a retirement pot of $ 150,000.
If Ramsey redeems the money to pay off a mortgage, you will likely miss out on $ 1.75 million in retirement, compared to putting the money into an independent retirement account (IRA) and maintaining contributions.
And even if you hadn't made further contributions, you could have received $ 1 million by the end of 20 years.
For example, let's say you start over and put every penny you save off getting mortgage payments into a new IRA.
That would leave you with only $ 567,000 in retirement – less than half the amount you otherwise could have had.
The return on your investments is not guaranteed
That might sound conclusive. But it is obviously based on assumptions.
In that case, you'd have to earn around 10 percent annual return on your $ 150,000 for 20 years to reach $ 1 million.
It's not impossible, though. But you may think these returns are unlikely over such a long period of time. And that math ignores the risk of a stock market crash.
As MarketWatch looked at the history of the time it took the Dow Jones Industrial Average (DJIA) to recover from crashes over the past 120 years, it found:
19 years after the 190 crash, 325 years after the 1929 crash, 16 years after the 1965 crash, 6 years after the 2008 crash
In other words, the DJIA has spent more than half of the past 120 years recovering from crashes.
If your 401 (k) or IRA gets into a future downturn, Ramsey's $ 1 million goal may become unattainable.
Why typing your 401 (k) might be a good idea
In his Forbes article Laurence Kotlikoff argues that we can't ignore the risk of the stock markets, which right now is pretty much the only place you can hope for Ramsey's 10 percent return per year.
He says the difference between stock market returns and returns on 30-year Treasuries (1.577% per year on the day this was written in October 2020) is entirely due to the difference in risk.
You have a much better chance of getting your money back from the U.S. Treasury Department than your (or your 401 (k) or IRA) stock portfolio.
And that's the only reason your stock returns can be five times higher: because they're five times riskier.
In order to Kotlikoff suggests that you should consider Treasurys' returns as your "real" return on your equity investments to discount your very real risk.
Or, in an even worse scenario, say the stock market declines 50% like it did in 2008-2009 just like you are retiring.
Execute your numbers based on that, and the case of robbing your 401 (k) to pay off a mortgage could suddenly make sense.
That said, if you pay more than 3% interest on your mortgage – which most people do – you are saving more by paying it off than you will be making by putting the same money into pension funds.
But do you buy the theory when so many retire each year with much better returns than they would get from Treasurys?
What we think
For us both Ramseys and KotlikoffThe arguments involve magical thinking. They are both right on their own terms.
But both make assumptions that may or may not stand the test of time.
Our argument is a little more pedestrian.
In short, you will need the money in your 401 (k) to lead a decent life when you retire.
And the withdrawal penalty and tax implications of taking money out make it a very expensive business.
Avoid touching your 401 (k) in the worst of circumstances. That is why it is called a "hardship case" after all.
Also, most homeowners have several options for getting rid of their mortgage early – and these are preferable to a 401 (k) withdrawal.
Here's how to pay off your mortgage early without touching your 401 (k)
If you are thinking of using your 401 (k) to pay off a mortgage, you are probably looking for an instant win: a mortgage this month, debt free next month.
That is understandable. But with a little strategy and patience, you could get rid of your mortgage a few years earlier – without taking any money out of your golden years.
Here are five ideas:
Short term refinancing – Many lenders allow you to refinance one 15 year mortgage or a 10 year mortgageand some allow even shorter ones. Of course, your monthly payments are higher than those of a longer loan. But you should be paying less interest overall – and paying off your loan much sooner
Pay more than necessary each month – – Pay extra (as much as you can afford) with every monthly payment. You could be mortgage-free years before and see serious savings on your total interest
Make 13 mortgage payments a year instead of 12 – this will also help you to repay your loan early and save interest. You can do this by simply making one extra payment each year or switching to bi-weekly mortgage payments
Recast your mortgage – ONE Recast the mortgage is cheaper and involves less effort than refinancing. Recasting the loan means that you are making a large lump sum and the lender will adjust your loan balance and repayment schedule to reflect this.
Pay a flat rate – Few mortgages these days have prepayment penalties. So you can usually pay a lump sum at any time, even if your lender doesn't reformulate your loan. This can still help you repay the loan earlier
Any of these strategies can help you repay your mortgage earlier and lower your overall interest costs.
And none of them affect the money you put away for retirement. Win win.
Check your eligibility for a shorter mortgage term (October 27, 2020).
COVID-19 and 401 (k) withdrawals – Still no free money
On March 27, 2020, the Coronavirus Law on Help, Assistance and Economic Security (CARES Law) came into force.
The CARES Act abolished the 10 percent 401 (k) withdrawal penalty for people under 59½ years of age. This allowed you to spread your tax liability over three years: the current one and the next two.
To be clear, you still have the same total tax liability. The law only gives you extra time to pay.
And there are some important conditions that you need to be aware of.
The provisions of the CARES Act are due to end in 2020
According to the Fidelity website, the CARES Act states that you have the right to: "… if you, your spouse or loved one have been diagnosed with COVID-19 or have had adverse financial consequences as a result of COVID-19."
Believed to be an economic victim of the pandemic.
At the moment, however, the provisions of the law only apply until the end of 2020. This is a time-limited offer. Of course, these provisions could be expanded. But there is certainly no guarantee.
Additionally, your 401 (k) provider may not allow penalty-free withdrawals under CARES law.
Each 401 (k) program has its own rules. And it is possible that your provisions do not comply with the provisions of the CARES Act. Contact HR or view your policy online to see where regulatory updates are most likely.
401 (k) loans vs. 401 (k) hardness withdrawals
If you think 401 (k) funds are the best way to repay your mortgage, it is important to understand that there are two different ways to tap 401 (k) money: a 401 (k) – Loan or hardship withdrawal.
Each method has different implications for your current and future finances.
Also note that each 401 (k) program has its own set of rules. So we can only generalize.
You will need to check with your 401 (k) provider to determine which rules apply to your specific situation.
Use a 401 (k) hardship case to repay your mortgage
A 401 (k) hardship withdrawal (often simply referred to as a "401 (k) withdrawal") is the version that comes with a 10 percent withdrawal penalty and tax liability.
Unlike a loan, a 401 (k) payout will permanently deplete your retirement assets because you will not be able to restore your 401 (k) to what it was before the payout.
Yes, you can start over or keep adding money. However, it is very unlikely that you would do as well in retirement as if you left your 401 (k) intact.
Use a 401 (k) loan to repay your mortgage
Withdrawing money from your 401 (k) in the form of a loan is likely to cause less damage to your retirement assets than a hardship case.
This is because you need to repay a 401 (k) loan in order to restore your savings.
But it may not give you enough money to pay back your mortgage. Because you can only withdraw half of your savings – or $ 50,000, whichever is lower – in any 12 month period.
The CARES law has lifted this upper limit. But does that apply to your 401 (k)? And do you have time to retire before the law expires?
Equally important is that you must repay your loan (plus interest) within five years. So you will likely have high monthly payments for this time.
After all, it is very likely that you can only get a loan from a 401 (k) managed by your current employer. Few programs allow former employees to borrow.
Your money, your choice
In general, experts do not recommend using your 401 (k) to pay off a mortgage.
But everyone has their own financial situation. So there is no single answer.
If you are determined to use your retirement savings, the first thing to do is consider moving carefully. It also doesn't hurt to seek advice from a financial advisor.
This person can assess the impact of this step on your personal finances and make an informed recommendation on what to do.
If a 401 (k) payout doesn't seem like the right move, consider one of the many other ways you can get your mortgage prepaid.
There is a chance that you could shorten your repayment time and save interest without the help of your 401 (k) funds. Especially with today's low mortgage rates.
Check your new plan (October 27, 2020)