Using Your 401(k) to Pay Off a Mortgage

There are some understandable questions you might encounter as you plan for retirement: Is it sensible to be squirreling away money in an employer-sponsored retirement plan such as a 401(k) while simultaneously making a hefty monthly mortgage payment? Could it be better, in the long run, to use existing retirement savings to pay down the mortgage? That way, you’d substantially reduce your monthly expenses before you leave behind work and its regular paychecks.

There’s no single answer as to whether it’s prudent to discharge your mortgage prior to retirement. The merits depend on your financial circumstances and priorities. Here, though, is a rundown of the pros and (compelling) cons of the move to help you decide whether it might make sense for you.

Pros to Discharging Your Mortgage

Here are the factors in favor of living mortgage-free in retirement, even if it means using up much or all of your 401(k) balance in order to do so.

Increased Cash Flow

Since a mortgage payment is typically a hefty monthly expense, eliminating it frees up cash for other uses. The specific benefits vary by the age of the mortgage holder.

For younger investors, eliminating the monthly mortgage payment by tapping 401(k) assets frees up cash that can be used to meet such other financial objectives as funding college expenses for children or purchasing a vacation property. With time on their side, younger workers also have the optimal ability to replenish the drawdown of retirement savings in a 401(k) over the course of their working years.

For older individuals or couples, paying off the mortgage can trade savings for lower expenses as retirement approaches or begins. Those reduced expenses may mean that the 401(k) distribution used to pay off the mortgage needn’t necessarily be replenished before leaving the workforce. Consequently, the benefit of the mortgage payoff persists, leaving the individual or couple with a smaller need to draw income from investment or retirement assets throughout retirement years.

The excess cash from not having a mortgage payment may also prove beneficial for unexpected expenses that could arise during retirement, such as medical or long-term care costs not covered by insurance.

Elimination of Interest

Another advantage of withdrawing funds from a 401(k) to pay down a mortgage balance is a potential reduction in interest payments to a mortgage lender. For a conventional 30-year mortgage on a $200,000 home, assuming a 5% fixed interest rate, total interest payments equal slightly more than $186,000 in addition to the principal balance. Utilizing 401(k) funds to pay off a mortgage early results in less total interest paid to the lender over time.

However, this advantage is strongest if you’re barely into your mortgage term. If you’re instead deep into paying the mortgage off, you’ve likely already paid the bulk of the interest you owe. That’s because paying off interest is front-loaded over the term of the loan. Use a mortgage calculator to see how this might look.

Estate Planning

Additionally, owning a home outright can be beneficial when structuring an estate plan, making it easier for spouses and heirs to receive property at full value, especially when other assets are spent down before death. The asset-protection benefits of paying down a mortgage balance may far outweigh the reduction in retirement assets from a 401(k) withdrawal.

Cons to Discharging Your Mortgage

Against those advantages of paying off your mortgage are several downsides—many of them related to caveats or weaknesses to the pluses we noted above.

Reduced Retirement Assets

The greatest caveat to using 401(k) funds to eliminate a mortgage balance is the stark reduction in total resources available to you during retirement. True, your budgetary needs will be more modest without your monthly mortgage payment, but they will still be significant. Saving toward retirement is an overwhelming task for most, even when a 401(k) is available. Savers must find methods to outpace inflation while balancing the risk of retirement plan investments.

Contribution limits are in place that cap the total amount that can be saved in any given year, further increasing the challenge.

For 2021, the 401(k) annual contribution limit is $19,500 and for 2022, the limit is $20,500. Those aged 50 and older can make an additional catch-up contribution, which is limited to $6,500 each year.

With the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in December 2019, you can now contribute past the age of 70½. That’s because the act allows plan participants to begin taking required minimum distributions (RMDs) at age 72.

Due to these restrictions, a reduction in a 401(k) balance may be nearly impossible to make up before retirement begins. That’s especially true for middle-aged or older workers and therefore have a shorter savings runway in which to replenish their retirement accounts. The cash flow increase resulting from no longer having a mortgage payment may be quickly depleted due to increased savings to make up a retirement plan deficit.

A Hefty Tax Bill

If you’re already retired, there is a different kind of negative tax implication. Overlooking the tax consequences of paying off a mortgage from a 401(k) could be a critical mistake. The tax scenario might not be much better if you borrow from your 401(k) to discharge the mortgage rather than withdraw the funds outright from the account.

Withdrawing funds from a 401(k) can be done through a 401(k) loan while an employee is still employed with the company offering the plan as a distribution from the account. Taking a loan against a 401(k) requires repayment through paycheck deferrals. However, the loan could lead to costly tax implications for the account owner if the employee leaves their employer before repaying the loan against their 401(k).

In this situation, the remaining balance is considered a taxable distribution unless it is paid off by the due date of their federal income tax, including extensions. Similarly, employees taking a distribution from a current or former 401(k) plan must report it as a taxable event if the funds were contributed on a pretax basis. For individuals making a withdrawal prior to age 59½, a penalty tax of 10% is assessed on the amount received in addition to the income tax due.

The Loss of Mortgage-Interest Deductibility

In addition to tax implications for loans and distributions, homeowners may lose valuable tax savings when paying off a mortgage balance early. Mortgage interest paid throughout the year is tax-deductible to the homeowner. The loss of this benefit may result in a substantial difference in tax savings once a mortgage balance is paid in full.

It’s true, as we noted earlier, that if you’re well along in your mortgage term, much of your monthly payment pays down principal rather than interest, so it is limited in its deductibility. Nonetheless, homeowners—especially those with little time left in their mortgage term—should carefully weigh the tax implications of paying off a mortgage balance with 401(k) funds before taking a loan or distribution to do so.

Decreased Investment Earnings

Homeowners should also consider the opportunity cost of paying off a mortgage balance with 401(k) assets. Retirement savings plans offer a wide array of investment options meant to provide a way to generate returns at a greater rate than inflation and other cash equivalent securities. A 401(k) also provides for compound interest on those returns because taxes on gains are deferred until the money is withdrawn during retirement years.

Typically, mortgage interest rates are far lower than what the broad market generates as a return, making a withdrawal to pay down mortgage debt less advantageous over the long term. When funds are withdrawn from a 401(k) to pay off a mortgage balance, the opportunity to earn money on the investments is lost until new funds replenish the 401(k), if it’s replenished at all.

The Bottom Line

Keep in mind that you enjoy the likely appreciation in the value of your home regardless of whether you’ve discharged its mortgage. Financially, you might be better off overall to leave the funds in your 401(k) and enjoy both their possible appreciation and that of your home.