Using Your 401(k) to Pay Off Your Mortgage - SmartAsset

The government offers several incentives for retirement accounts like 401(k)s. For instance, they’re a tax-deferred investment, meaning you won’t pay taxes on them until you withdraw. 401(k) deposits also don’t count as taxable income during the year that you make them, so you can use them to lower your tax liability. Just as they incentivize retirement investment, the government penalizes people who withdraw early. But in some scenarios, it may make sense to dip into your 401(k) early. One of these scenarios is to pay your mortgage. Before deciding to take money out of your retirement fund to pay for your mortgage you should weigh the pros and cons. You may also want to get expert advice from a financial advisor about your unique situation.

Should You Pay Off Your Mortgage with Your 401(k)?

Paying your mortgage off can feel like a relief, especially if the debt hurts your mental health. But you don’t want to make this decision solely on that emotion. Your retirement is your nest egg. Before you dip into your retirement savings, there are four questions you need to answer.

1. How Old Are You?

If you’re under the age of 59.5, you’ll face an extra 10% penalty for withdrawing from your 401(k) early. That’s a huge blow that makes paying down your mortgage not worth it. That means if you take out $50,000 to pay down the mortgage, you’ll automatically be penalized $5,000. That’s before taxes, too, so your actual cash-in-hand will be even smaller.

2. How Much Do You Owe?

How much you owe on your mortgage factors in a couple ways. For example, let’s say you owe $200,000 on your mortgage. If you pay off your mortgage, not only will you not have to make the mortgage payment, but you’ll also avoid paying the interest on $200,000. However, if you take $200,000 out of your 401(k), you’ll have to pay tax on the distribution. For $200,000, this could result in owing thousands in taxes.

3. How Much Have You Saved?

Depending on how big your nest egg is, paying off your mortgage with your 401(k) could make sense. However, look at your other savings or assets first. If you need to stretch your 401(k) into retirement, it may make more sense to keep it invested and use other assets to pay down your mortgage.

4. What’s Your Expected Rate of Return?

This is a big one. If your 401(k) is reliably delivering a 7% rate of return, you should think before touching it. That rate of return is free money. For example, if you have $1 million in your 401(k), at 7% annually, that’s earning you $70,000 a year. As you dip into your 401(k), this annual payment will shrink. If you take $300,000 out to pay off your mortgage, your annual growth will go from $70,000 down to $49,000.

Pros of Paying Off Your Mortgage with Your 401(k)

When you pay off your mortgage, regardless of the method, it can feel rewarding and provide you with plenty of breathing room in your finances. Here are some of the most important things to consider that can be considered positives in your decision-making process.

Reduced Monthly Costs: There’s something to be said about not having to pay your mortgage every month. If your mortgage payment is $2,500 a month, that’s $30,000 every year that you don’t need to worry about. If you’re on a fixed income, eliminating this mortgage expense could drastically reduce your regular costs.
Avoiding or Reducing Interest Payments: By paying off your mortgage early, you’ll cut down on the total interest you pay. For instance, if you have a 30-year fixed-rate mortgage of $400,000 at 7% interest, you’ll pay $558,035.59 in interest alone over that 30 years. The younger your mortgage is, the more this has an impact. That’s because of the way mortgages amortize. Borrowers pay the interest owed up front, gradually paying more of the principal over the loan term. If you’re in the final five years of your 30-year mortgage, you’ve already paid most of the interest. However, if you’re in the first five years of your mortgage, you still have most of the interest ahead of you.
Planning Your Estate: Owning your home in full can make it easier for your heirs. When estate planning, you may decide to pay off your mortgage so your heirs receive it at full value. As you near the end of your life, owning the home outright can protect the asset for those you’re leaving it to.

Cons of Paying Off Your Mortgage with Your 401(k)

Using your retirement funds always comes with some potential drawbacks to consider to ensure it’s the right decision for your situation. Here is what you should be aware of before moving forward.

Reduced Retirement Assets: Paying off your mortgage with your 401(k) can significantly eat into your retirement assets, especially if you have a large balance left to pay. For instance, if you’re paying off a $200,000 mortgage and you have $1,000,000 in retirement savings, that’s 20% of your retirement.
Loss of Potential for Retirement Asset Growth: If you’re seeing 7% returns annually on your retirement savings, by reducing your 401(k), you’re reducing your returns. This annual growth can be a large piece of what allows you to retire. By taking out a significant chunk to pay off your mortgage, you’re cutting how much returns you can get.
A Sizable Tax Bill: Perhaps one of the biggest deterrents to paying off your mortgage with a 401(k) is your tax bill. Remember, all the money you withdraw from your 401(k) will be counted as income on your income taxes. That means that if you withdraw $200,000 to pay off your mortgage, you’re going to pay taxes on it. This could bump you up to another tax bracket, raising your effective tax rate. If you’re going to pay off your mortgage with a 401(k) withdrawal, be prepared to pay a hefty tax bill.

The Bottom Line

Paying off a mortgage with a 401(k) can make sense in specific scenarios. It removes the emotional weight of the debt, plus it can make things easier for your heirs when estate planning. However, you need to consider the cons carefully. You will end up paying taxes and you don’t want to dip into your retirement savings to the point of it affecting your quality of life.

Tips for Retirement and Mortgages

Want to create a financial plan that grows your money and provides for a secure retirement? You might benefit from talking to a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Use SmartAsset’s mortgage calculator to work out how much a new mortgage payment will be, see how the mortgage amortizes and how much interest you will pay throughout the loan.
Check out SmartAsset’s income tax calculator, you can estimate how much tax you will pay due to a large withdrawal from your 401(k).