Broker Check
Why Cashing Out an IRA to Pay Off Mortgage Debt Might Not Be the Best Idea

Why Cashing Out an IRA to Pay Off Mortgage Debt Might Not Be the Best Idea

May 21, 2024

I had a great call with a client. They wanted to know if it would be a good idea to cash out their IRAs and just pay off their mortgage. In short, the answer was no.

As you enter retirement, working with a qualified Financial Planner to help manage your finances and wealth may become even more crucial. Maybe you too have thought of cashing out your retirement accounts such as an IRA (Individual Retirement Arrangement) or 401k to pay off your home mortgage. It’s easy to see the desire in wanting to do so thinking, “Just be debt free and have a lower need for income”. The implications are much more complicated though.

While the thought of being mortgage-free in retirement is appealing, it may be essential to understand the potential drawbacks of this strategy. Here are some thoughts to explore why cashing out an IRA to pay off a mortgage might not be the best idea and provide alternative approaches to consider. Remember, decisions like this may be crucial to get it right. They are often irrevocable, they cannot be undone. Feel free to contact our office and we can talk through, possibly run the numbers on, decisions like these before you pull the trigger.

Tax Implications: More Than You Bargained For

When you withdraw funds from a traditional IRA, those funds are subject to income tax. A substantial pre-tax IRA or 401k withdrawal to pay off your mortgage could push you into a higher tax bracket, resulting in a hefty tax bill.

As an example, we’re going to look at Mr. and Mrs. Mortgage Owner.  In 2024, Mr. & Mrs. Mortgage owner have income from IRAs, some pension income, and are both collecting Social Security in retirement. Their household Adjusted Gross Income (AGI), is $170,100. This currently puts them in a 22% Marginal Bracket, with an Effective Rate of 14.8%, for a Total Tax of $20,422 in 2024.

If Mr. Mortgage chose to cash out part of his IRA to pay off the full $250,000 mortgage, that would thrust Mr. Mortgage’s AGI up to $387,800. Their new Marginal rate would be 32%, with a higher Effective Rate of 20.6% and a total tax now of $79,849. That’s a 291% increase in tax. Yikes!

 

Current Tax Year 2024

Tax Year 2024 + $250,000 additional IRA withdrawal

AGI before additional withdrawal

$170,100

$170,100

Additional IRA withdrawal

n/a

$250,000

New AGI

$170,100

$420,100

Total Tax Due

$20,422

$79,849

Marginal Rate

22.0%

32.0%

Effective Rate

14.8%

20.6%

 See attached: Holistiplan_Scenario Analysis_Mrs. and Mrs.  Mortgage Owner

That’s a hefty burden.

I didn’t even bring up the fact that your IRMAA/Medicare Premium brackets may also increase, pushing your monthly Medicare bill by $458.50/month, or $5,502/year more!

Additionally, if you’re under 59½, you’ll also face a 10% early withdrawal penalty. While this is less likely for those at or near retirement age, it’s an important consideration for younger retirees.

For more details on understanding tax implications, visit our comprehensive guide on IRA Withdrawals and Taxes.

Opportunity Cost: The Power of Compounding

IRAs grow tax-deferred, meaning you don’t pay taxes on the gains until you withdraw the funds. By cashing out your IRA, you lose the opportunity for future growth on those investments. Over time, the power of compounding can substantially increase the value of your retirement savings. For example, an IRA balance of $200,000 growing at an average annual rate of 6% could grow to over $358,000 in 10 years. By withdrawing these funds early, you might miss out on a potential growth of $158,000, which can have a significant impact on your long-term financial security.

Learn more about the importance of compounding in our article on How Compound Interest Works.

Retirement Income: Ensuring Long-Term Stability

Your IRA is a critical source of retirement income. Withdrawing a large sum to pay off your mortgage can deplete your retirement savings, leaving you with less money to cover living expenses, healthcare costs, and other unforeseen expenses. Ensuring you have enough income to last throughout your retirement may be essential, and reducing your IRA balance can jeopardize your financial stability.

For strategies on maintaining a stable retirement income, check out our Retirement Income and the Traditional Portfolio page.

Low-Interest Rates: Weighing the Costs

In recent years, mortgage interest rates have been relatively low. If your mortgage interest rate is lower than the expected rate of return on your IRA investments, it may make more sense to keep your mortgage and allow your investments to continue growing. For instance, if your mortgage rate is 3.5% and your IRA is earning an average of 6%, you should be financially better off keeping the mortgage and letting your IRA grow.

Now that we’re currently in a world where mortgage interest is closer to 6% or 7%, these numbers have changed.  Your decision-making process may change. Remember, your mortgage interest may be partially deductible. If so, the actual out of pocket cost comes down!

Explore our calculators on Comparing Mortgage Terms for more information and the post on Home Mortgage Deductions.

Liquidity: Flexibility for the Unexpected

Maintaining your IRA provides you with liquidity and flexibility. Life is full of surprises, and having accessible funds can be a crucial safety net. Whether it’s for unexpected medical expenses, home repairs, or other emergencies, having liquid assets available can help you manage financial surprises without taking on additional debt or financial stress.

It’s really important to emphasize the premium of holding onto your capital for unforeseen expenses.

Check out our article Maintaining a Mortgage in Retirement

Looking at the Big Picture

Before making any significant financial decision, it may be essential to evaluate your overall financial plan. This includes considering your entire portfolio of assets, income sources, expenses, and long-term goals. A financial planner can help you assess whether paying off your mortgage with IRA funds aligns with your broader financial objectives. In many cases, a balanced approach that manages debt while preserving retirement savings may be more beneficial.

Alternative Strategies to Consider

If paying off your mortgage is a priority, here are some alternative strategies that may be more financially advantageous:

  1. Making Extra Payments

Instead of cashing out your IRA, consider making extra mortgage payments from other sources of income or savings. This can help you pay off your mortgage faster without depleting your retirement savings. Even small additional payments can significantly reduce the total interest paid over the life of the loan and shorten the repayment period.

  1. Refinancing Your Mortgage

Refinancing to a lower interest rate or a shorter loan term can reduce your monthly payments and the overall interest cost. This strategy can make your mortgage more manageable and reduce the financial burden without tapping into your IRA. Be sure to evaluate the costs associated with refinancing, such as closing fees, to ensure it’s a financially sound decision.

Learn more about refinancing options in our Can I Refinance My Mortgage? Calculator..

  1. Keeping your mortgage intact.

This is the strategy that no change is better than change.

Conclusion: Plan Intentionally

While the idea of entering retirement mortgage-free is attractive, cashing out an IRA to achieve this goal may not be the best financial move. The tax implications, loss of investment growth, reduced retirement income, and loss of liquidity can outweigh the benefits of paying off your mortgage early. Instead, consider alternative strategies that align with your overall financial plan and maintain the integrity of your retirement savings.

Working with a financial planner can help you navigate these complex decisions and develop a retirement strategy that balances debt management with long-term financial security. By carefully evaluating your options and considering the long-term impact on your retirement savings, you can make informed decisions that support a comfortable and financially stable retirement.

Remember, each individual’s financial situation is unique. It may be essential to consider your specific circumstances, goals, and needs when making decisions about your retirement finances. Taking a thoughtful, informed approach will help ensure you achieve the retirement you’ve worked so hard to attain. And to contact our office BEFORE you make decisions like these.