Dear Tax Talk,
I am 75 years old and just was terminated after 21 years with the same corporation. I have a 401(k) as a retirement fund, and accumulated about $300,000. Seven months ago (before I knew about my termination), my wife and I decided to extract $180,000 to pay off the mortgage of our only residence in preparation for retirement. We paid off our mortgage, using the money that remained after taxes on that $180,000.
I will be rolling the rest of that 401(k) into an IRA. We are working on our taxes for 2014. In addition to the 20% I paid when receiving the withdrawal to pay off our mortgage, the IRS is asking for another $15,000. I realize now that it might have been better if I had waited a couple of years after rolling over the 401(k), but the deed is done.
Question: Are there any tax loopholes available, because we, in effect, rolled the money into our home? Or do we just suck in our pride and acknowledge our mistake and pay some 28% on that withdrawal?
— Robert
Dear Robert,
You are correct. There is no tax loophole available for taking money out of your retirement account to pay off your mortgage. As you have already figured out after the fact, the income is added to your other income, which may throw you into a higher tax bracket, and the withholding that was taken out of the distribution does not cover everything owed to Uncle Sam.
You sent your question in on April 14, so I hope you went ahead and filed the return and paid the balance due. If, for some reason, you held back and extended your return and did not pay in the additional tax you owe, then file your return as soon as possible. Remember, an extension is only for filing the return; all taxes are due on April 15 or you incur interest and penalties.
IRS late fees are onerous!
- If you don’t file your return, you will owe an additional 5% each month of any tax amount that is due, up to 25%.
- If you don’t pay what you owe, theIRS will levy an extra 0.5% each month of your due tax amount to your overall IRS debt.
- If you don’t file or pay, the 0.5% failure-to-pay penalty will accrue, up to 25% of what you owe, until the tax is paid.
- That means the total penalty for failure to file and pay could amount to a whopping 47.5% of your tax bill!
- On top of all that, you’ll owe interest on the overdue amount. Determined quarterly, the interest rate is the federal short-term rate plus 3%, compounded daily.
- Other penalties may apply.
Source: IRS
I frequently see questions from people who are getting ready to retire and want to take money out of their retirement account to pay off their mortgage. It is a good idea to meet with a tax professional before making these decisions so you understand the ramifications of taking out large sums from retirement accounts at one time. Even though you were not subject to the additional 10% tax, you still had to report the income. They can help you figure out whether it is best to take your distribution amounts over several years in order to minimize the tax burden. Keep in mind that once you pay off the mortgage, there is no longer any interest deduction.
Thanks for the great question and all the best to you and your wife in your retirement years.
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FAQs
Key Takeaways. Paying down a mortgage with funds from your 401(k) can reduce your monthly expenses as retirement approaches. A paydown can also allow you to stop paying interest on the mortgage, especially if it's fairly early in the term of your mortgage.
How to avoid 20% tax on 401k withdrawal? ›
Minimizing 401(k) taxes before retirement
- Convert to a Roth 401(k)
- Consider a direct rollover when you change jobs.
- Avoid 401(k) early withdrawal.
- Take your RMD each year ...
- But don't double-dip.
- Keep an eye on your tax bracket.
- Work with a professional to optimize your taxes.
If you are in a high tax bracket, max out your 401(k), earmarking some of those dollars for a future payoff. A: Transitioning into retirement with a home paid off is often a good goal.
Is there a tax break for using 401k to buy house? ›
Not only do you avoid the 10% early withdrawal penalty, but the amount you withdraw will not be subject to income tax. There are other benefits to a 401(k) loan as well. It doesn't count toward your debt-to-income ratio (DTI), and it won't be counted by credit bureaus.
Is it smart to pay off house with retirement? ›
Key Takeaways. Paying off a mortgage can be smart for retirees or those who are just about to retire if they're in a lower income tax bracket, It can also benefit those who have a high-interest mortgage or who don't benefit from the mortgage interest tax deduction.
At what age should you pay off your mortgage? ›
To O'Leary, debt is the enemy of any financial plan — even the so-called “good debt” of a mortgage. According to him, your best chance for long-term financial success lies in getting out from under your mortgage by age 45.
At what age is 401k withdrawal tax-free? ›
Once you reach 59½, you can take distributions from your 401(k) plan without being subject to the 10% penalty. However, that doesn't mean there are no consequences. All withdrawals from your 401(k), even those taken after age 59½, are subject to ordinary income taxes.
How can I withdraw money from my 401k for tax-free? ›
The easiest way to borrow from your 401(k) without owing any taxes is to roll over the funds into a new retirement account. You may do this when, for instance, you leave a job and are moving funds from your former employer's 401(k) plan into one sponsored by your new employer.
Do you get taxed twice on a 401k withdrawal? ›
Do you pay taxes twice on 401(k) withdrawals? We see this question on occasion and understand why it may seem this way. But, no, you don't pay income tax twice on 401(k) withdrawals. With the 20% withholding on your distribution, you're essentially paying part of your taxes upfront.
Is there a disadvantage to paying off a mortgage? ›
The Downside of Mortgage Prepayment
Prepaying your mortgage ties up your funds in your home, potentially leaving you with less liquidity for other financial needs or opportunities.
To safeguard your financial health, prioritize paying off high-interest debts, adding to an emergency fund, and paying into a retirement account. Home equity can benefit you financially, but retirement savings may be critical to supplement Social Security payments and pay for essentials later in life.
What happens if I pay an extra $200 a month on my mortgage? ›
If you pay $200 extra a month towards principal, you can cut your loan term by more than 8 years and reduce the interest paid by more than $44,000. Another way to pay down your mortgage in less time is to make half-monthly payments every 2 weeks, instead of 1 full monthly payment.
What proof do you need for a hardship withdrawal? ›
The administrator will likely require you to provide evidence of the hardship, such as medical bills or a notice of eviction.
What documentation is needed for a hardship withdrawal? ›
Show the address of the affected property, • Show the amount necessary to prevent foreclosure or eviction, and • Show a future eviction or foreclosure date in the future. In addition, if a statement, letter, or tax document is provided, it must threaten eviction or foreclosure.
What is a hardship withdrawal? ›
Removing funds from your 401(k) before you retire because of an immediate and heavy financial need is called a hardship withdrawal. People do this for many reasons, including: Unexpected medical expenses or treatments that are not covered by insurance.
What are the pros and cons of cashing out 401k? ›
401(k) withdrawals
Pros: You're not required to pay back withdrawals and 401(k) assets. Cons: Hardship withdrawals from 401(k) accounts are generally taxed as ordinary income. Also, a 10% early withdrawal penalty applies on withdrawals before age 59½, unless you meet one of the IRS exceptions.
Should you stop contributing to a 401k to pay off debt? ›
If you have low-interest rate loans and expect higher returns on the investments in your 401(k), it may be a good strategy to contribute to your 401(k) while chipping away at your debt—making sure to prioritize paying off high-interest rate debt.
