You want to get out of debt, including your mortgage, so you think it may be a good idea to use your 401K savings. While we are all for consumers getting out of debt, the one time we wouldn’t recommend that you pay off your mortgage is if you have to use your retirement funds to do so. Your 401K funds should be left untouched until you are at least 59 ½, if not later.
The opportunity cost of draining your 401K just to own your home free and clear is so large that it’s simply not worth it.
Still not convinced? Keep reading to learn the main reasons you shouldn’t touch your 401K.
You’ll Pay Taxes and Penalties
If your 401K is like most others, your earnings grow tax-deferred. Once you withdraw those funds, you’ll have to pay taxes on them. Pulling out a large chunk, say $200,000 to pay off your mortgage means a very large tax liability.
In addition to that tax liability is the 10% penalty you will pay. If you are even a day younger than 59 ½ years old, you’ll pay that 10% penalty to the IRS. A person in an average tax bracket could see a loss of 30% – 40% of their 401K balance. If you are in a high tax bracket, you may lose as much as 50% of your balance.
The money you’d save on interest by paying your mortgage off early would easily be swallowed up by the taxes and penalty.
Your Interest Won’t Compound
When you save money in your 401K, not only does the original investment earn interest, but your interest earns interest. If you withdraw money from your 401K, you lose out on the compounding. This could leave you with thousands of dollars less than you need when you retire.
Even if you try to play ‘catch up’ and make up for the money you withdrew, you can’t make up time or interest. You’ve lost that opportunity for good. All that you can do is continue saving moving forward and hope that you have enough for retirement.
You Lose Your Tax Break
Paying mortgage interest has its advantages. Even though it may kill you to know that you are paying interest to keep your mortgage outstanding, you may use it to decrease your tax liability. You can write off the interest you pay on your primary house’s mortgage. This may help you owe less at tax time. If you don’t have that write off, you may owe more at tax time.
When you combine the higher tax bracket with the lack of retirement funds you’ll have at retirement, it doesn’t make financial sense to use your 401K to pay off your mortgage.
You Won’t Have Diversified Investments
Putting all of your money into your home isn’t smart. What if we have another housing crisis and you lose value in your home? You may not have any other investments to offset this loss, which could leave you financial distress.
When you have money invested in your home, your 401K, and personal investments, you diversify the risk. If something bad happens in one market, hopefully the other markets remain steady and make up for that loss. Putting all of your eggs in one basket is never recommended, especially when you are talking about something as big as your home and/or retirement savings.
We recommend that you keep your retirement savings right where they are and let them grow. If you want to make extra payments towards your mortgage to help lower the balance and pay less interest, go for it as long as it doesn’t deplete your retirement savings. You’ll need your retirement savings when you actually do retire. Hopefully, by then you won’t have to worry about your mortgage payment any longer and you’ll have the best of both worlds – money to retire and no mortgage payment.Click to See the Latest Mortgage Rates»