Q: How can we take money out of 401(k), pay off our mortgage and not pay taxes on it all if we do it all at the same time? Can any of it be deferred? The amount we’d want to take out is $105,000?
A: Unless you’re in danger of losing your house, you generally shouldn’t take money out of a 401(k) and use it to pay off a home loan.
Why? Because your money is growing inside your 401(k) at a faster rate than you’re paying out for your loan. Also, your mortgage interest may be deductible if you itemize on your federal income tax return.
If you’ve recently refinanced, you’re probably paying less than 5 percent for your mortgage. (I just refinanced to a 15-year at 3.75 percent.)
If you itemize, your net interest rate is somewhere around 3.5 to 4 percent. That’s basically like free money, and over time you’ll do a lot better by keeping the cash inside your 401(k).
In addition, if you’re under 59 1/2, you’ll not only pay taxes, but you’ll also pay a 10 percent penalty on your withdrawal.
So the real question is why would you want to take out that much money to pay off your mortgage? And if you did, that much of a withdrawal from your 401(k) would probably put you in a higher tax bracket causing you to pay even more federal income taxes on the amount you take out.
The only way to get tax-free cash is to borrow from your 401(k). But, again, I don’t recommend it. If you lose your job, you’ll have to replace all the cash within 60 days, plus you’ll be losing out on any return your retirement cash would generate inside your 401(k). The risks are extremely high that you could be caught short and wind up losing your home if you can’t come up with enough cash.
My suggestion is to keep your 401k money where it is and focus on finding additional ways to save in your budget to throw more cash at your mortgage.