Video: Marginal tax rates explained: https://youtu.be/uCFmdlBvQXI
Recently a subscriber e-mailed me asking a question regarding their parent’s 401(K). There question was as follows:
Hi Mike, my mom has been retired from the workforce now for several years and is wondering if it would be wise to use her 401(K) to pay off the existing mortgage on her home?
The short answer is it depends, but by the end of this video I believe you will the tools and information necessary in order for you to make this decision for yourself.
1. In this video we are going to discuss the pros and cons as well as factors that should be taken in consideration before you start withdrawing from your 401(K) to pay off your home.
2. Secondly if you decide you want to go through with paying off your mortgage early with your 401(K) we will discuss a strategic way to go about that is process so you can pay the least amount of tax possible.
Three pros of paying off your home with your 401K include:
1. You will have peace of mind knowing you own it out right.
2. You will be saving money on interest
3. You will need less money to live on going forward because you will no longer have a mortgage payment.
Three cons of using 401(K) to pay of mortgage
1. You give up the potential compounding interest impact of your 401(K) investments and possibly trading your investments for a lower rate of return based on the home mortgage interest rate.
2. Assuming you do not have other sources of income outside of your 401(K) You run the risk of becoming house rich and cash poor which could potentially put you in a position later on where you have to take on debt because you have no other available funds.
3. Without careful planning you might pay more taxes than you need to on your 401(K) distributions in order to pay off your mortgage.
Specific factors that I would suggest you take into account in this decision making process:
1. What is your annual mortgage rate?
2. What is average annual rate of return on your 401(K) over the past 5 – 10 years? Is it higher or less than your mortgage rate? (I find that most people I speak with have absolutely no idea what the answer to this question is.) So if you do not know ask someone to help you figure this out or call the brokerage company where your 401(K) assets are invested.
3. What is marginal tax rate since you retired? This is important when determining how much tax you will have to pay when you withdrawal from your 401(K). You can get a rough idea of your income tax rate based on the 2018 tax tables. I’ll provide a link in the description section of this video where you can go to find those. I’ll also link up a video I did to give you step by step guide lines of how to determine that.
4. How much would actually you need to withdraw from your 401(K) to pay off your home net of taxes?
5. Do you have emergency fund of 3 – 6 months worth of expenses saved up for emergencies that arise?
6. Do you have other sources of income to get by besides social security? How will you get by if emergencies arise?
7. Are you ok with taking risk in the markets by keeping your money invested?
If you decide that ultimately you want to use your 401(K) to pay down your mortgage this is how I would suggest you go about doing it.
– First determine your outstanding mortgage balance.
– Next, remember that your 401(K) distributions are taxed at ordinary income tax rates. Ordinary income rates are based on your marginal tax rates which follow the tax brackets I mentioned earlier in this video.
– What you want to avoid is paying more tax on your 401(K) distributions than you need to.
– To minimize your tax burden you want to do some basic tax planning and to the best of your ability determine how much total income you will have for the year from all sources of income before pulling out additional amounts from your 401(K).
– Based on that income projection determine how far away your income is from the next tax bracket.
– Now, consider pulling a smaller amount of extra money from your 401(K) so you stay under the next tax bracket threshold. This will allow you to pull this money out of your 401(K) at a lower tax rate.
– The next year do the same process again, and keep doing this process until your mortgage is completely paid off.
– By spreading out your distributions from your 401(K) and paying off your mortgage a little more slowly you might be able to save hundreds or even thousands of dollars of additional income taxes that you would have otherwise paid had you taken the money out all at once.
Money and Life TV : Should I Use My 401(K) to Payoff Mortgage? When to Use 401(K) to Payoff Mortgage if Retired