ByJustin Pritchard, CFP®
Beginning retirement with no debt might sound appealing. After all, you’re on a fixed income, and it’s unlikely that you’ll go back to work and start earning an income in your final years of life (although some people work part-time during retirement to stay engaged and supplement other income sources).
So, does it make sense to use retirement funds to pay off a mortgage loan completely when you stop working? If your only debt is a home loan, it may feel satisfying to wipe the slate clean and simply pay living expenses and taxes.
As with most financial questions, it’s complicated—but we’ll break down the pros and cons here so you’re better prepared to make an informed decision.
It’s crucial to understand the potential tax (and other) costs of cashing out.
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Advantages of Withdrawing Retirement Funds for Your Home Loan
Some people are comfortable with keeping debt and making a monthly payment. But for others, the benefits of eliminating debt are clear.
No More Monthly Payment
By paying off your mortgage loan, you get rid of one of your biggest monthly expenses in retirement. Yes, you’ll still have healthcare expenses and other costs, but reducing your monthly obligations gives you more breathing room and could reduce stress as you prepare for retirement.
Stop Paying Interest
A home loan might be a substantial amount—well over $100,000—that generates meaningful interest charges. By paying down the debt, you reduce the financial drain on your resources. Plus, if your money is sitting in cash-like investments or a bank account, it’s probably not earning as much in interest as you’re paying on the mortgage. You might save tens of thousands of dollars by wiping out that debt.
No Worries About Market Movements
Your willingness to take investment risks may decrease as you approach retirement. That makes sense, and we know that the “sequence of returns” issue makes big losses problematic in the years surrounding your retirement date. You might view a lump sum mortgage payment out of your retirement funds as a “guaranteed” return on the interest costs you avoid going forward.
While there are certainly good reasons to take money from your IRA or 401(k) to pay off a mortgage, there are also reasons for leaving the money in retirement accounts.
Potential Pitfalls of Taking Money Out
Before you decide on anything, review your strategy with your CPA and your financial planner. It’s critical to address all of the details, and this page doesn’t necessarily cover everything involved in the decision. If you have your heart set on getting rid of the mortgage, it might make sense to do it in stages.
A Large Tax Bill (And Other Costs)
When you withdraw funds from pre-tax retirement accounts to pay off a home loan, you typically create a substantial tax bill. Those costs may offset any benefits you get from getting rid of the mortgage debt. You pay a large tax expense today instead of paying modest interest charges in the coming years.
Example: Assume you owe $150,000 on your home, and you have assets available to withdraw. For simplicity, you and a spouse get $36,000 per year in Social Security benefits, and you withdraw $36,000 per year from your pre-tax retirement accounts for income.
In this scenario:
- You’re in the 12% federal income tax bracket (you can get a very rough, oversimplified estimate here).
- You might pay roughly $2,692 in federal income tax.
- You might be able to comfortably pay your mortgage during retirement.
But what if you withdraw $150,000 from your IRA to pay off the mortgage?
If you do so, your income is substantially higher for the year:
- You’re in the 24% federal income tax bracket (although you don’t pay that on every penny of income).
- You might pay roughly $34,191 in federal income tax—an increase of $31,499.
- You could need to withdraw at least $181,499 to cover the loan balance plus the increase in taxes (and we’re ignoring state income tax).
- More of your Social Security income is taxable, which contributes to the increase above.
- That large withdrawal could also affect your Medicare premiums in a few years, thanks to the IRMAA surcharge. You could pay an additional $600 for one year, for example, but you might not view that as a tax issue.
- If you’re under the age of 59.5, you might pay an additional 10% penalty tax on the amount you withdraw (unless you qualify for an exception). That’s an additional $15,000.
Remember that most of your monthly payment might go to principal if you’re many years into your mortgage loan. An amortization schedule can tell you how much is going toward interest charges, which may help you decide what’s best.
The tax consequences alone might be enough to spoil the deal. But that’s okay—at least you get an answer and you know why you’re doing what you’re doing. There may be other reasons to leave money in your retirement accounts.
Granted, you’ll pay taxes on those funds anyway when you take distributions from your 401(k), TSP, or other retirement plans. But by taking funds out slowly, you can manage taxes and potentially dodge some of the issues above.
Access to Funds
When you put money into your home equity, you may have a hard time accessing those funds in an emergency. For example, suppose you face major medical expenses in retirement. In that case, it’s nice to have easily accessible funds in a retirement account—you can zap the money into your bank account within a few days. But if the money is tied up in your home, you may need to resort to a home equity loan or a reverse mortgage, which can be time consuming and expensive.
Creditor Protection?
Money in 401(k), 403(b), 457, and IRA accounts is often protected from creditors, to some degree. Pulling that money out and paying off your home loan could potentially put your assets at greater risk. State laws might protect your home, but there may be situations that result in you losing the home. Check with an attorney licensed in your state to understand any potential pitfalls.
Less Money for Spending?
Taking withdrawals from your retirement savings may leave you with less spending money in retirement. The amount you can safely spend over your remaining years often depends on how much money you have available. Granted, you can take income from home equity using a reverse mortgage, but you lose a lot of flexibility and your family faces certain risks with that approach.
There’s also the question of growth. When discussing the question of paying off your home versus investing, people often point toward this: the potential to earn more on investments than you pay in interest. There are, of course, no guarantees, but it could be financially “optimal” to keep your money invested with an appropriate level of risk. Or maybe not—only time will tell.
