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Mortgages and 401(k)s
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December 22, 2000: 6:20 a.m. ET
Taking money early out of a 401(k) to pay your mortgage means heavy taxes
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NEW YORK (CNNfn) - You can't stand the thought of being in debt, so you borrowed from your 401(k) to pay off your mortgage. Now you're sleeping better at night, but you're worried about the taxes and penalties.
Part of the money you borrowed came from after-tax contributions, and part came from what your company matched. What do you do at tax time?
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VIDEO
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Certified Financial Planner Doug Flynn answers questions on Your Money's viewer mail segment. |
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In response to a reader's question, Doug Flynn, a certified financial planner in New York, said your cost may be as much as 50 percent of the amount of you withdrew when you add in penalties and state and federal taxes.
Flynn recently appeared on CNNfn's Your Money, and answered some questions for CNNfn.com.
Steve from Colorado writes: I recently paid off my first and only home mortgage, by taking approximately $25,000 from my after-tax contributions to my 401(k). As it was explained to me, this $25,000 total included by law a portion of the earned interest/matching contributions. That portion was approximately $12,000. The IRS deducted 20 percent income tax prior to distribution on the part I hadn't paid taxes on yet. I am 42, married, with two children. What other penalties apply (if any) on this money?
Steve, premature withdrawals from IRA accounts are subject to a mandatory 10 percent early withdrawal penalty, as well as ordinary federal and state income tax.
Depending on your tax bracket, the total cost of these withdrawals can be as much as 50 percent or more on the taxable portion of the distribution, when you combine the penalty, and all federal and state taxes! Therefore be prepared for an additional tax burden above the 20 percent that was already withheld.
What you definitely should have done is asked more questions BEFORE you decided to pay off your mortgage and take such a distribution in the first place.
Since mortgage interest is tax-deductible, the after-tax "cost of money," or interest rate, is usually very low. And presumably, your 401(k) was invested with a goal of earning equity rates of return. Therefore, the lesson here is to always compare the rate earned on the investments you plan to liquidate with the net, after-tax cost of the loan you are considering paying off.
Every week, CNNfn.com brings you video from Your Money, where experts answer your questions about financial planning issues. If you have a question, you can e-mail the show at yourmoney@cnnfn.com.
At first glance it seemed that the $25,000 you took was from your "after-tax contributions."
In reality, this money came from the after-tax portion of your 401(k). This consisted of $13,000 in actual contributions, and $12,000 in earnings and matching dollars. Therein lies the problem. Now we certainly do not know all of the circumstances surrounding your decision, but we probably would have advised you to not take the taxable portion out.
Most firms will allow you to leave those dollars in and just take your actual contributions -- which would have been tax-free. Unfortunately, you now have additional taxable income, and no more tax-deductible mortgage interest.
Do you have a question about your 401(k)? Ask experts on CNNfn.com a question at retirement@cnnfn.com.
As a result, you should now consider consulting with a tax adviser to determine how the loss of the interest deduction will effect your tax situation. Also, you may wish to begin thinking about establishing a system to pay your local, school and other real estate taxes yourself since this was probably taken care of by your former mortgage holder. 
* Disclaimer
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