Using Retirement Money to Pay Off the Mortgage

For many folks, the urge to pay off a mortgage seems to strike when the layoff notice arrives.

That's my conclusion based on e-mails I've received during the current recession. More than once, readers have asked whether it's a good idea to take a lump sum from their retirement nest egg and make a giant payment to wipe out their mortgage balance.

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The thinking is that their post-layoff life will be easier if they can live mortgage-free. Of course, they are correct. But that doesn't mean paying off a mortgage in full after a job loss is always a good idea, even if you've got the funds available to do so.

In fact, in most cases, I would say it's a bad idea.

Consider the example below.

Question: My wife just received a 60-day advance layoff notice. She will be 59½ when she leaves. My question is: Would it be wiser to use a portion of her 401(k) to pay off our $100,000 mortgage balance (30 yrs, 4.75 percent), or leave it all in her 401(k) to continue drawing interest (currently 3.64 percent), and continue paying mortgage on a single income?

-- D.P., Decatur, Ala.

Answer: For the time being, D.P., I would say it's best to leave the money in your wife's 401(k) account and continue making monthly payments.

The main reason that I say this is that a $100,000 lump sum withdrawal from her 401(k) is going to trigger a big tax bill at a particularly bad time. Even though your wife is old enough to avoid the 10 percent early withdrawal penalty, she would still owe federal and state income taxes on any amount she takes from her 401(k) account.

If your family income is in the middle range, the combined federal and state tax rates could easily be 30 percent or higher. That means to pay off a $100,000 mortgage balance, your wife actually would have to withdraw nearly $143,000 -- $100,000 for the mortgage and about $43,000 to cover the taxes.

These numbers assume you're in the 25 percent federal tax bracket and Alabama's 5 percent tax bracket. Of course, they could be higher or lower depending upon your actual income, but you can be almost certain that a one-time $143,000 401(k) withdrawal will lift you into a higher tax bracket than you otherwise would have been in.

An added wrinkle you also need to consider is the timing of the withdrawal from the 401(k). If your wife is in line to receive any kind of severance package when she loses her job, her total income for 2009 could be significantly higher than it was in 2008, even though she's out of work.

From your question, D.P., it appears your wife will be employed for about three quarters of this year and thus be eligible to receive about 75 percent of her annual salary. Add to that the potential severance pay plus unemployment benefits and and there's a good chance your wife is likely to see an unexpected spike in her 2009 income -- just as she is adjusting to life without a paycheck.

Again, add a $143,000 401(k) withdrawal to the 2009 income mix, and your overall family tax bill rate is going up.

Now, let me emphasize one point, D.P.

I'm not suggesting you avoid withdrawals of any size from her retirement savings. If your income alone is not enough to cover the family mortgage and other household expenses, then it's quite reasonable to draw a portion from your wife's 401(k) account while she is out of work.

But I would do that one month at a time with small withdrawals rather than a large single withdrawal.

An even better idea, D.P., would be to use non-401(k) sources -- such as any severance pay or any non-retirement savings -- to make monthly payments at least through the end of 2009. Then if needed, make monthly withdrawals from the 401(k) account in 2010 when your family income will likely be lower if your wife has been unable to find work by then.

Finally, also keep in mind the low interest rate of 4.75 percent you're paying on your mortgage compared to the 3.64 percent rate of return you're say your wife is earning on her 401(k) account. That's not a big difference, and the difference gets even smaller when you take into account your possible tax savings from the mortgage interest deduction.

On the whole, D.P., I understand the urge to pay off the mortgage now that your wife is facing unemployment. We'd all like to rid ourselves of our monthly mortgage burdens, but in this case I think the important thing is to avoid making a bad situation worse with a higher tax bill.

For now, sit still and re-evaluate the situation next year.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.

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