Wealth Wise: Should We Downsize or Drain Our 401(k) to Pay Off Our Home?
In our retirement advice column, Wealth Wise, we help a reader navigate a heart-wrenching choice: Tap a 401(k) to save the lake home they love, or sell it to protect their financial future.
Ellen B. Kennedy
Dear Wealth Wise: My husband just retired from his job due to early-onset dementia. I have heart failure and collect disability benefits. We owe $255,000 on our home and pay $8,500 a year in property taxes and homeowners insurance. Our mortgage rate is 5.34%. Utilities are around $399 per month. My husband wants to use his $300k 401(k) to pay down the mortgage. I want to move to a more affordable location. But we're in a very walkable neighborhood close to a beautiful lake, and I hate to give it up. We argue about this every day. Help!
— Love My Lake Home
Dear "Love My Lake Home": When you retire in a home and neighborhood you know and love, it can make your post-working years that much more rewarding. But what if it's a struggle to keep up with your housing costs?
The Urban Institute says that over the past 20 years, the share of senior households considered severely cost-burdened — meaning spending more than half of their income on housing — has nearly doubled. And that burden isn't limited to rent or mortgage payments. Rising homeowners insurance premiums and property taxes are also big drivers.
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Here, we have a couple struggling to afford their home. They have a moderate mortgage interest rate and high property taxes.
The husband is willing to empty his 401(k) to pay off the mortgage, while the wife thinks moving to a more affordable place is the smarter choice. At the same time, both would clearly rather stay put.
It's a tough situation, especially since it's compounded by the couple's health problems. Here's how the experts suggest navigating it.
Raiding your 401(k) may not solve your problem
If you're carrying a mortgage with a moderate interest rate, you might assume that tapping your 401(k) to pay it off is a smart move. The sooner you eliminate that loan, the more money on interest you can save.
But John Davis, Financial Planner at JKD Financial, warns that the math may not work out.
"One thing people often miss when they look at a 401(k) balance is that the IRS essentially owns a big chunk of it," he says. "If you were to pull out the full $300,000 in a single year to pay off that $255,000 mortgage, you’d likely trigger a tax bill of $60,000 to $70,000, assuming you’re in a moderate bracket."
Davis also cautions that 401(k) providers are legally required to withhold 20% of distributions for federal taxes immediately.
"That means you’d only actually get $240,000 in your hand, which wouldn't even be enough to pay off the $255,000 mortgage," he says. "You’d end up with a huge tax bill next April and still have a mortgage balance."
Then there are tax penalties to consider. We assume that our reader and her husband are over age 59½, since she hasn't expressed concern about 10% penalty for early withdrawals from a 401(k). However, if they are younger than 59½, they may possibly qualify for an exemption due to their significant health issues, though they would still have to pay ordinary income tax on the withdrawal.
Emptying your 401(k) means losing flexibility
Taxes aside, there's a real danger to using your 401(k) to pay off a mortgage. As Chad Gammon, CFP and owner of Custom Fit Financial, says, "With the 401(k), you have liquidity and flexibility to use that money for needs that come up, such as medical. Paying off the mortgage opens up some cash flow, but not to the extent of having the 401(k)."
Gammon agrees, noting that while it's possible to borrow against home equity, that doesn't offer the same level of flexibility as having money in a 401(k).
"Money that is in a 401(k) is easier to use than money that is tied into a personal residence," he insists. "If they pay off the mortgage, they may be forced to get a home equity loan on the home they thought they just paid off. That very well could be at a higher interest rate and they'd be worse off than where they are today."
"With today's housing prices, downsizing can sometimes cost just as much as staying put." — John Davis
If you're going to move or downsize, do it carefully
In a situation like this, moving to a more affordable location or downsizing might seem like a logical money-saving choice. But Davis says it's important to do your research first to make sure that's actually the case.
"For many people in your shoes, downsizing is a much cleaner way to free up cash, but only if you're careful," he warns. "With today's housing prices, downsizing can sometimes cost just as much as staying put once you factor in moving costs and higher interest rates on a new place."
Keep in mind that if you're buying a home in a retirement community, you may be subject to expensive HOA fees that can rise over time. This isn't to say that a new place definitely won't save you money, but you'll need to get a solid handle on all of the costs involved before making a move.
One strong argument for downsizing: She and her husband may exclude up to $500,000 in capital gains when selling their primary residence as a couple. Their equity profit from selling the house would likely be tax-free, whereas the traditional 401(k) withdrawal would probably incur significant taxes.
Consider a middle-ground solution
Raiding your 401(k) to pay off your mortgage leaves you fairly illiquid. A better option, says Davis, may be to accelerate mortgage payments but carry that loan a while longer.
"If you really want to stay in that walkable neighborhood you love," Davis explains, "pay the mortgage down faster but over a longer period — say five to 10 years. Instead of one big withdrawal, take smaller monthly or annual distributions."
This approach, adds Davis, satisfies the urge to get rid of debt and could result in interest savings. But importantly, it spreads out the tax hit so you aren't jumping into a much higher tax bracket all at once.
"Plus," says Davis, "it keeps your 401(k) assets available to generate income for your other needs if the house becomes too much to handle later on."
A final word from Wealth Wise — healthcare should come first
One of the most concerning elements of this reader's question is the double burden of her own health issues and her husband's early-onset dementia (defined as dementia starting before age 65). Unfortunately, it's hard to predict the trajectory of this type of dementia, but our reader may face several years when her husband needs extensive care that she may not be physically able to provide.
As she balances staying in the home she loves versus downsizing, she should also consider how to pay for long-term care. Tapping the 401(k) for healthcare may prove a smarter move than focusing on the house. Moreover, staying in the home may be untenable if it is not adapted for aging in place.
Working with a financial adviser may help her untangle the emotional and financial pressures she'll face in the next few years. We wish her all the best.
Read More
- You May Not Want to Downsize in Retirement: Here's Why
- We Are Retired, Mortgage-Free, With $970K in Savings. My Husband Wants to Downsize to Lower Our Costs, but I Love Our House. Help!
- My Beloved Husband Has Early-Stage Dementia. He Is 'Doing Well,' but How Do I Protect Our $1.6 Million Savings Right Now?
- I'm 63 With an Aging House That Needs Repairs, but I Might Move to a Retirement Community In a Few Years. Is It Worth Making Those Fixes?
