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Why you shouldn’t use your 401(k) to pay off a mortgage

Peter Warden
The Mortgage Reports editor

Paying off a mortgage with 401(k) funds? Almost always a bad idea

Are you thinking of withdrawing money from your 401(k) to pay off a mortgage?

Well, think very carefully before you do. Because doing so is very likely to cost you dearly in the long run.

And, dipping into your 401(k) is rarely necessary. There are plenty of ways to pay off your mortgage early without touching the money you’ve saved for retirement.

We’ll cover those 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 (Dec 3rd, 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 takes funds away from your retirement nest egg.

Not only are you removing a lump sum from your retirement account, but you’re losing years’ worth of accrued interest on that money.

Say you’re 35 years from retirement. If your 401(k) accrues interest at a rate of around 10 percent, the money you’re taking out could potentially have doubled itself 3 to 5 times over.

The returns you’re missing out on are much larger than the original sum withdrawn.

401(k) withdrawal penalties are hefty

Leaving aside your depleted retirement savings, there are more immediate financial implications when you withdraw money from your 401(k). (At least, if you’re younger than 59½ years.)

These penalties apply to 401(k) withdrawals rather than 401(k) loans.

Typically, those who haven’t reached 59½ must pay a 10 percent penalty money withdrawn from their 401(k). That’s a $100 fee for every $1,000 taken out.

There’s also a tax hit during the year the withdrawal is made.

Every cent taken out would be taxed in the same year at the individual’s normal tax rate. The extra ‘income’ might even push them into a higher tax band.

Add those taxes to the 10 percent penalty, and you’d lose anything between 30 percent and half of the funds you took out.

Withdrawing 401(k) funds when you’re over 59½ years

Once you’ve passed the magic age of 59½ years, you no longer have to pay a 10 percent penalty for withdrawing funds.

But the tax implications remain the same.

When The Washington Post addressed this very issue in 2019, it consulted Julie Welch, a CPA and personal financial planner in Leawood, Kansas. She said:

“While you would not incur a penalty for early distribution of the funds from an IRA or 401(k) since you are over age 59½, any distributions you take and use to pay off a mortgage would be income to you and subject to tax.”

The case against (and for) using 401(k) funds to pay off a mortgage

It’s 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 move.

However, writing in Forbes in April 2020, Boston University economist Laurence Kotlikoff made the opposite case.

To give you a fair look at 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 a mortgage is a bad idea

Dave Ramsey’s website highlights the dangers of pulling from your 401(k) to pay off a mortgage.

It gives an example of someone age 45 years with a $150,000 pension pot.

By cashing that in to pay off a mortgage, Ramsey reckons you stand to miss out on $1.75 million dollars in retirement, compared to if you’d put the money into an independent retirement account (IRA) and kept up contributions.

And even if you made no further contributions, you might have ended up with $1 million at the end of 20 years.

On the other hand, say you start over and put every cent you save from having no mortgage payments into a new IRA.

This would leave you with only $567,000 at retirement — less than half the amount you might have had otherwise.

Returns on your investments are not guaranteed

That might sound conclusive. But it’s obviously based on assumptions.

In this case, you’d have to have a yield of roughly 10 percent on your $150,000 every year, for 20 years, to get to $1 million.

True, that’s not impossible. But you may think those returns unlikely over such a long period. And this math ignores the risk of a stock market crash.

When MarketWatch looked at the history of the time it’s taken for the Dow Jones Industrial Average (DJIA) to recover from crashes over the last 120 years, it found:

  • 19 years following the 1903 crash
  • 25 years following the 1929 one
  • 16 years following the 1965 one
  • 6 years following the 2008 one

In other words, the DJIA has spent more than half the last 120 years recovering from crashes.

If your 401(k) or IRA gets caught up in a future downturn, Ramsey’s $1 million target may become unattainable.

Why tapping your 401(k) could be a good idea

In his Forbes article, Laurence Kotlikoff argues that we can’t ignore the riskiness of stock markets, which currently are pretty much the only place you could hope for Ramsey’s 10 percent return every year.

He says the difference between stock market returns and yields on 30-year Treasurys (1.577% per year on the day this was written in October 2020) is entirely down to the difference in risk.

You stand a much better chance of getting your money back from the U.S. Treasury than from your (or your 401(k)’s or IRA’s) stock portfolio.

And that’s the only reason stocks yield may be five-times more: because they’re five-times riskier.

So Kotlikoff suggests you should count the yield on Treasurys as your “real” return on your stock investments, thus discounting your very real risk.

Or in an even worse scenario, say the stock market dives 50% as it did in 2008-2009, just as you enter retirement.

Run your numbers based on that, and the case for raiding your 401(k) to pay off a mortgage might suddenly make sense.

I.e. If you’re paying a rate over 3% on your mortgage — which most people are — you’d save more by paying it off than you’d earn by putting the same money in retirement funds.

But do you buy the theory when so many retire each year with much better returns than that they’d get from Treasurys?

What we think

To us, both Ramsey’s and Kotlikoff‘s arguments involve some magical thinking. They’re both right according to their own terms.

But they both make assumptions that may or may not stand the test of time.

Our argument is a bit more pedestrian.

In short, you are going to need the money in your 401(k) to have any sort of decent life when you retire.

And the withdrawal penalty and tax implications of taking money out make it a very expensive business.

So you shouldn’t touch your 401(k) except in the most dire circumstances. That’s why it’s called a “hardship withdrawal” after all.

Plus, most homeowners have multiple options for getting rid of their mortgage early — and these tend to be preferable to a 401(k) withdrawal.

How to pay off your mortgage early WITHOUT touching your 401(k)

If you’re thinking of using your 401(k) to pay off a mortgage, you’re probably looking for an instant hit: this month a mortgage, next month debt-free.

That’s understandable. But with a little strategy and patience, you could free yourself from your mortgage several years early — without taking money from your golden years.

Here are five ideas:

  1. Refinance to a shorter term — Plenty of lenders will let you refinance to a 15-year mortgage or a 10-year mortgage, and some allow even shorter ones. Of course, your monthly payments will be higher than with a longer loan. But you should pay less interest overall — and pay your loan off much earlier
  2. Pay more than you need to each month Pay extra (as much as you can afford) with each monthly payment. You could be mortgage-free years earlier and make serious savings on your total interest
  3. Make 13 mortgage payments each year instead of 12 — Again, this will help you pay off your loan early and save on interest. You can do this by simply making one extra payment per year, or by switching to bi-weekly mortgage payments
  4. Recast your mortgage — A mortgage recast is less costly and involves less hassle than a refinancing. Recasting the loan means you make one large, lump-sum payment and the lender adjusts your loan balance and repayment schedule to reflect this.
  5. Pay a lump sum — Few mortgages nowadays have prepayment penalties. So you can typically pay a lump sum at anytime even if your lender won’t recast your loan. Doing so can still help you pay off the loan earlier

Any of these strategies can help you pay off your mortgage at an earlier date, and reduce your total interest costs.

And, none of them will affect the money you’ve put away for retirement. Win-win.

Verify your eligibility for a shorter mortgage term (Dec 3rd, 2020)

COVID-19 and 401(k) withdrawals — Still not free money

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) came into law.

The CARES Act abolished the 10 percent 401(k) withdrawal penalty for those under 59½ years. And it allowed you to spread your tax liability over three years: the current one and the two succeeding ones.

To be clear, you still have the same overall tax liability. All the Act gives you is extra time to pay.

And there, are some important conditions to be aware of.

CARES Act provisions set to end in 2020

According to Fidelity’s website, you’re eligible under the CARES Act: ” … if you, your spouse, or dependent have been diagnosed with COVID-19, or you have experienced adverse financial consequences due to COVID-19.”

So, presumably, being an economic victim of the pandemic counts.

But, at the moment, the Act’s provisions apply only until the end of 2020. So it’s a limited-time offer. Of course, those provisions might be extended. But there’s certainly no guarantee.

In addition, your 401(k) provider might not allow penalty-free withdrawals under the CARES Act.

Each 401(k) program has its own rules. And it’s possible that yours doesn’t accommodate the CARES Act’s provisions. So check with HR or see your rule book online, where updates following the legislation are most likely to appear.

401(k) loans vs. 401(k) hardship withdrawals

If you do decide that 401(k) funds are the best way to pay off your mortgage, it’s important to understand that there are two different ways to tap 401(k) money: a 401(k) loan or a hardship withdrawal.

Each method has different implications for your current and future finances.

Also note that each 401(k) program has its own rules. So we can only generalize.

You need to check with your 401(k) provider to see which rules apply to your specific situation.

Using a 401(k) hardship withdrawal to pay off your mortgage

A 401(k) hardship withdrawal (often simply called a ‘401(k) withdrawal’) is the version that comes with a 10 percent withdrawal penalty and tax liability.

Unlike a loan, a 401(k) withdrawal permanently depletes your retirement savings because you can’t restore your 401(k) to its pre-withdrawal situation.

Yes, you can start over again or keep adding funds in. But you’re highly unlikely to be as well off when you retire as you would be leaving your 401(k) intact.

Using a 401(k) loan to pay off your mortgage

Taking money out from your 401(k) in the form of a loan will likely do your retirement savings less damage than a hardship withdrawal.

That’s because when you take a 401(k) loan, you have to pay it back and so restore your savings.

But it may well not give you enough money to pay off your mortgage. Because you can only take out half your savings — or $50,000, whichever is less — in any 12-month period.

True, the CARES Act lifted that cap. But does it apply to your 401(k)? And would you have time to make your withdrawal before the Act expires?

As importantly, you have to pay back your loan (plus interest) within five years. So you’ll likely have high monthly payments for that time.

Finally, it’s very likely that you can take a loan only from a 401(k) that is managed by your current employer. Few programs let former employees borrow.

Your money, your choice

Generally, experts do not recommend using your 401(k) to pay off a mortgage.

But everyone has their own unique financial circumstances. So there’s no one-size-fits-all answer.

If you’re determined to use your retirement savings, consider the move carefully first. It might not hurt to seek the advice of a financial adviser, either.

This person can assess the impact this step will have on your personal finances and make a well-informed recommendation about what to do.

If a 401(k) withdrawal doesn’t seem like the right move, consider one of the many other ways you can pay off your mortgage early.

Chances are, there’s a way you can cut your repayment time and save on interest without the help of your 401(k) funds. Especially at today’s low mortgage rates.

Verify your new rate (Dec 3rd, 2020)