Can you use money from a retirement account to pay off your mortgage?
The short answer to your question is that you can use money from a retirement account to pay off your mortgage but you may need to pay a penalty and taxes, depending on how old you are and the type of account. Additionally, withdrawals from your retirement account deplete your financial resources and may not make financial sense if your mortgage rate is low.
Although paying off your mortgage sounds like a great idea because you eliminate your monthly payment, reduce your interest expense and improve your cash flow, using your retirement savings may not be the optimal way to do it. We outline some of the key considerations of this approach below including tax consequences, lost investment income, potential penalties and tapping into retirement funds you may need some day.
When you withdraw money from an IRA or 401(k), those funds are taxed as ordinary income. If you take out a significant amount of money, you may move into a higher tax bracket and pay a higher tax rate. The amount of taxes you pay on the retirement account withdrawal may offset any financial benefit you gain by paying off your mortgage.
For example, if you take out $100,000 from your IRA and the withdrawal plus your other income puts you in the 32% federal tax bracket, you pay $32,000 in taxes on the withdrawal alone plus you also need to consider applicable state and investment taxes. I recommend that you compare the taxes you pay on the funds you take out of your account to the interest you save by paying off your mortgage early.
If the taxes are more than your total remaining mortgage interest expense, then you lose money by paying off your mortgage. Returning to the above example, if you only save $25,000 in mortgage interest then paying $32,000 or more in taxes does not make much financial sense.
You also need to consider the income you lose because that money is no longer earning a return in your retirement account. Rates of return vary based on the type of investment and other factors but in many cases the average investment return generated by your retirement account over the long run is higher than the interest rate on your mortgage. If you are thinking about using funds in a Roth IRA account the lost income may be even greater because investment income is tax-free.
In short, you are worse off financially if you reallocate your retirement funds to an investment such as a mortgage that potentially provides a lower rate of return.
Another consideration is that by paying off your mortgage you lose your interest tax deduction benefit. Although the value of this benefit declines as you pay less interest over the course of your loan, the deduction effectively reduces the cost of your mortgage. If you pay off your mortgage early you forego this tax benefit.
Your age is another important factor. If you withdraw money from an IRA or 401(k) account before the age of 59 ½, you are usually required to pay a 10% penalty in addition to any taxes you owe although you can withdraw contributions made to a Roth IRA at any time without paying taxes or a penalty. So if you are younger than 59 ½ and you want to use retirement funds to pay off your mortgage, the penalty may cost you even more, which further reduces the financial benefit.
We should highlight that you can withdraw up to $10,000 ($20,000 if your are married) from an IRA to buy your first home without a penalty. You may also be able to use this first-time home buyer exception to pay down or off the mortgage balance on your first home although we recommend that you confirm this strategy with a tax professional.
If you are using funds from a Roth IRA, a withdrawal of earnings under the first-time home buyer exception may be both penalty and tax free as long as the account has been open at least five years. If you are using funds from traditional IRA, you need to pay income taxes on the withdrawal but there is no penalty according to the exception guidelines.
One final point to keep in mind is less financial and more practical. Simply put, you may need your retirement account funds in the future. You may have the resources to pay off your mortgage right now but if your situation changes, you may find yourself in a financial bind if you have depleted your retirement savings.
Instead of withdrawing funds from your retirement account to pay off your mortgage it may make more sense to use other savings or investments. You can also consider taking out a loan from your retirement account, especially if you can repay the loan relatively soon. Using a retirement account loan may allow you to avoid certain penalties and reduce your taxes.
If you absolutely need to use your retirement funds to pay off your mortgage, you may want to spread the account withdrawals over multiple years. For example, take half the withdrawal in December and the other half the following January. This approach lowers your income in a single year and potentially reduces your tax burden.
In closing, because accessing retirement account funds can be complicated and potentially costly, we highly recommend that you consult a retirement specialist, tax planner or accountant to determine the strategy that is right for you.
Sources
"Retirement Topics - Exceptions to Tax on Early Distributions." IRS. Internal Revenue Service, October 29 2019. Web.
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