Should I clean out my 401(k) to pay off my mortgage?

The Credible Money Coach answers a reader’s question on the tax impact of cleaning out a 401(k). (Credible)

Dear Credible Money Coach,

I am contemplating taking all that I have saved in a 401(k). Will I be allowed to withdraw all of it at one time? I want to use part of it to help pay off my mortgage sooner now that I am over 59½ years old. I still intend to work longer. How does it affect me as far as taxes? — Shana

Thanks for your question, Shana! It may be possible for you to take every dollar out of your 401(k) in a lump sum, depending on the terms your employer set for your retirement account.

However, while being mortgage-free ahead of retirement is a great idea, I’m not sure depleting a retirement savings account is the best way to pay off a mortgage. Here’s why.

You could take a significant tax hit

A 401(k) is a tax-advantaged retirement account. Your contributions aren’t taxed before you put the money into the account. But any amount you take out is generally subject to federal income tax, and possibly state income tax, depending on where you live. This is true whether you make a withdrawal at 29, 59, or 79. 

If you take money out of a 401(k) before you’re 59½, that amount is also typically subject to a 10% penalty in addition to the regular tax, although there are some exceptions. Since you’re older than 59½, you won’t pay that penalty, but your withdrawal almost certainly will be taxed. And of course, the larger the amount you take out, the bigger the tax bill on it will be.

The tax rate that will apply to the withdrawn amount will be based on your total income for the year in which you make the withdrawal, and here’s where the tax hit can get even bigger. Without knowing your annual income or how much you have in your 401(k), I can’t give you an estimate of what your tax hit could be. But here’s an example of how a big withdrawal could affect your tax burden.

Let’s say your annual income is usually $75,000 a year, you file as single, and take the standard deduction. Your income will probably be subject to a 22% federal tax rate, and your federal tax bill will be around $9,500. But if your 401(k) withdrawal doubles your annual income to $150,000 and nothing else changes, your new tax rate will be 24%, and your tax bill will zoom up to more than $27,000.

Additional considerations

Shana, you also don’t say if this 401(k) is your only retirement savings or if you have money in other accounts like an IRA or a different employer 401(k). If this is your only retirement account, I strongly caution you against draining it completely, especially as it sounds like you’re close to your retirement age.

Even if you intend to continue working in retirement, it’s critical to have savings for your Golden Years. While withdrawing all your money and using it to pay off your mortgage will save you the interest you’d otherwise have paid on that home loan, it will also cost you all the earnings you could reap if you leave the money invested in your 401(k). That loss could potentially outstrip the interest savings you hope to get from a paid-off mortgage.

Other ways to pay off your mortgage faster 

If your goal is to pay off your mortgage faster and save money while doing so, refinancing your existing mortgage may be a good option for you. Although interest rates have risen in recent months, they’re still relatively low. If your mortgage is more than five years old, refinancing now could get you a much lower interest rate.

If you also choose a shorter repayment period — say 15 years instead of 30 — and make extra payments, you’ll pay off your mortgage even faster.

Another option might be a 401(k) loan, if your employer permits them. You can borrow against your 401(k) to pay down your mortgage, and then repay yourself at what’s likely to be a much lower interest rate. This would allow you to pay off your house, save on interest, and preserve your retirement funds.

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About the author: Laura Adams is a personal finance and small business expert, award-winning author, and host of Money Girl, a top-rated weekly audio podcast and blog. She’s frequently quoted in the national media, and millions of readers and listeners benefit from her practical financial advice. Laura’s mission is to empower consumers to live richer lives through her speaking, spokesperson, and advocacy work. She received an MBA from the University of Florida and lives in Vero Beach, Florida. Follow her on LauraDAdams.com, Instagram, Facebook, Twitter, and LinkedIn.