Is it a good idea to take money out of your 401k to pay off your mortgage?
For debts with lower interest rates, such as a home mortgage or student loan, taking a 401(k) withdrawal, and paying both income taxes and a possible 10% penalty on it, would make little financial sense.
Key Takeaways
Paying down a mortgage with funds from your 401(k) can reduce your monthly expenses as retirement approaches. A paydown can also allow you to stop paying interest on the mortgage, especially if it's fairly early in the term of your mortgage.
After other borrowing options are ruled out, a 401(k) loan might be an acceptable choice for paying off high-interest debt or covering a necessary expense. But you'll need a disciplined financial plan to repay it on time and avoid penalties.
Risk of default if unable to repay, leading to taxes and penalties. Requirement to repay loan in full upon leaving current job. Limits potential investment growth due to borrowed funds being outside the retirement account. Potential restrictions on loan eligibility and terms based on plan provider regulations.
Key Takeaways
The money you save from not paying off your mortgage early can give you more financial flexibility. Investing extra funds can potentially earn higher returns than you would save on mortgage interest. With extra cash flow, you can work toward other financial goals, such as saving for retirement.
Typically, when you withdraw funds from a 401(k) before age 59½, you incur a 10% penalty. This rule also applies if you withdrawn funds from your 401(k) for the purpose of buying a house. Therefore, a 401(k) withdrawal for a home purchase may not be best for some buyers.
This is where the rule of 55 comes in. If you turn 55 (or older) during the calendar year you lose or leave your job, you can begin taking distributions from your 401(k) without paying the early withdrawal penalty.
Don't forget that a 401(k) loan may give you access to ready cash, but it's actually diminishing your retirement savings. First, you may have to sell stocks or bonds at an unfavorable price to free up the cash for the loan. In addition, you're losing the potential for tax-deferred growth of your savings.
How does a 401(k) withdrawal affect your tax return? Once you start withdrawing from your traditional 401(k), your withdrawals are usually taxed as ordinary taxable income. That said, you'll report the taxable part of your distribution directly on your Form 1040 for any tax year that you make a distribution.
If the interest rate on your debt is 6% or greater, you should generally pay down debt before investing additional dollars toward retirement. This guideline assumes that you've already put away some emergency savings, you've fully captured any employer match, and you've paid off any credit card debt.
How do I avoid 20% tax on my 401k withdrawal?
The easiest way to borrow from your 401(k) without owing any taxes is to roll over the funds into a new retirement account. You may do this when, for instance, you leave a job and are moving funds from your former employer's 401(k) plan into one sponsored by your new employer.
Tax Disadvantages of 401(k) Plans
401(k)s are taxed at higher earned income rates, as opposed to lower capital gains rates. You will find yourself paying capital gains taxes on other types of investments such as real estate and regular growth accounts. So why the difference with the 401(k)?
If you withdraw money from your 401(k) before you're 59½, the IRS usually assesses a 10% tax as an early distribution penalty. That could mean giving the government $1,000, or 10% of a $10,000 withdrawal, in addition to paying ordinary income tax on that money.
Terms may apply to offers listed on this page. If your mortgage rate is higher than the return on your 401(k) investments, it might make sense to use your 401(k) to pay your mortgage. But the opportunity cost, plus taxes and a 10% penalty, could make it costly to withdraw money from your 401(k).
“Paying off your mortgage early seems impossible but it is completely doable and people do it all the time, but how can you do it and why would you want to put in the extra effort? Paying off your mortgage early will rev up your wealth building.”
To O'Leary, debt is the enemy of any financial plan — even the so-called “good debt” of a mortgage. According to him, your best chance for long-term financial success lies in getting out from under your mortgage by age 45.
In some cases, you might be able to withdraw funds from a 401(k) to pay off debt without incurring extra fees. This is true if you qualify as having an immediate and heavy financial need, and meet IRS criteria. In those circ*mstances, you could take a hardship withdrawal.
Generally, anyone can make an early withdrawal from 401(k) plans at any time and for any reason. However, these distributions typically count as taxable income. If you're under the age of 59½, you typically have to pay a 10% penalty on the amount withdrawn.
You can withdraw your contributions (that's the original money you put into the account) tax- and penalty-free. But you'll owe ordinary income tax and a 10% penalty if you withdraw earnings (i.e. gains and dividends your investments made inside the account) from your Roth 401(k) prior to age 59 1/2.
By age 50, you should have six times your salary in an account. By age 60, you should have eight times your salary working for you. By age 67, your total savings total goal is 10 times the amount of your current annual salary. So, for example, if you're earning $75,000 per year, you should have $750,000 saved.
Is it dumb to take money out of your 401k?
If you don't have much in savings, you might even be tempted to take money from your 401(k). But here's the deal: Taking an early 401(k) withdrawal is one of the worst moves you can make for your long-term financial future. We're talking a one-two punch of taxes and penalties that'll knock you out!
Key takeaways
A 401(k) loan may be a better option than a traditional hardship withdrawal, if it's available. In most cases, loans are an option only for active employees. If you opt for a 401(k) loan or withdrawal, take steps to keep your retirement savings on track so you don't set yourself back.
Repayment of the loan must occur within 5 years, and payments must be made in substantially equal payments that include principal and interest and that are paid at least quarterly. Loan repayments are not plan contributions.
Convert to a Roth IRA.
If you have a traditional 401(k), you can convert some or all of it to a Roth IRA. You'll have to pay taxes on the amount converted in the year of the conversion, but qualified withdrawals from a Roth IRA are tax-free in retirement.
401(k) Income Doesn't Change Benefits
You'll owe income tax on your 401(k) distributions when you take them, but not Social Security tax. The amount of your Social Security benefit won't be affected by your 401(k) taxable income.
