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Is it financially appropriate to borrow from your 401(k) or IRA to pay down mortgage or HELOC?

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In the past few weeks, we’ve received numerous emails from our readers asking why we don’t recommend using 401(k) or IRA money to pay off a mortgage or home equity line of credit. Here are two of the letters, along with our thoughts on how to think through your financial choices based on your own personal finances.

Q: My husband turns 65 next month, and his private medical disability payment (around $4,000 per month) will end. We have a monthly mortgage payment of $2,600 and one child with two years left in college. I take home $2,300 a month. Our home is currently worth $1.2 million, is close to downtown Washington, D.C., and a walkable metro stop. The value shouldn’t be going down.

Can we pay off our house by taking out $300,000 from his 401(k)? The 401(k) balance hovers around $900,000 right now. We’re not ready to move right now, so selling isn’t an option. I’ll be working for eight to 10 more years, and we’d have to move several hours away from here to get a price break on our next home purchase.

Q: I read your article titled “Options for funding home renovation.” Why didn’t you suggest or recommend that the homeowner take out a loan from their IRA and pay it back with interest to themselves over 10 years?

A: Thanks to all of our readers who wrote in with similar questions and similar suggestions. We have some strong feelings about when it is financially appropriate to borrow from your future via your 401(k) or IRA and when you should find another way.

Of course, having a substantial retirement account gives you options. If you’ve made saving and investing a priority through your decades of work, your 401(k) should be in fairly good shape for the day you decide to stop working. The stock market has quintupled since its low point in the Great Recession, bringing the total number of millionaires in the U.S. from 6.7 million in 2008 to nearly 22 million, according to the 2021 Global Wealth Report from the Credit Suisse Research Institute.

Unfortunately, it costs more to live. High levels of inflation can eat into your retirement savings quickly, which is why if you can lock in costs (like housing), you’ll have an easier time paying for the lifestyle you want.

But sometimes, life gets in the way of a good retirement plan. In your case, your husband has a medical disability and now that he is turning 65, those payments will end. Will he take Social Security? Assuming his payments are less than the $4,000 you’ve come to depend on, that will still leave your family income short each month.

What can you do now? In general, it’s almost never a good idea to take cash out of your 401k or IRA. In fact, we think this should be the place of last resort for two reasons: First, this is money to fund your retirement, whatever that looks like. If there is another way to get these funds, you should try. Second, taking money from your 401(k) can be expensive. If you take out the $300,000 and then you’ll owe another 25% (likely more) for federal and state taxes (if your state has state income tax). So, you can expect your balance to fall from $900,000 to $500,000 or less. If you’re under 59 1/2 years of age, you’ll pay a 10% penalty on top of taxes.

If you have a 401(k) that permits borrowing and hardship withdrawals, you’ll need to make a decision about whether you’re borrowing those funds (and repaying them with interest, the option our second correspondent raised) or taking a hardship withdrawal, where you are not required to repay the money, but you’ll owe taxes and possibly penalties.

Borrowing the funds has its own risks, even if you won’t pay taxes or penalties on the funds. According to Fidelity Investments, if you borrow funds from your 401(k) and you leave your job, you will have to repay those funds in a short time frame. Even if you don’t leave your job, you’ll generally need to repay the money with interest within five years. Depending on how your plan is set up at work, you may be limited in how much you can withdraw from your 401(k). If you have an IRA, you’ll have more flexibility in setting up the terms of the loan. But you’ll still have to make those payments each month, which is problematic if you don’t have enough cash to pay your bills now.

We get that you’re in a tough situation. Your take-home pay isn’t enough to cover your mortgage, let alone your other bills. And, it’s a permanent situation, meaning that you have to plan for the next few decades, not just a couple of years of rehab, say.

For some people in similar situations, the best answer would be to sell your home and rent something nearby that’s more affordable. You’d use up some of your $1.2 million over the next few years (is remote work a possibility?), but would have the cash you need to fund your lifestyle now, while allowing your 401(k) to grow for the foreseeable future.

But, you don’t want to sell. So, here are a few other ideas. Can you rent your home for more than it would cost you to carry it, using the excess income to rent a different home, one that’s more affordable? If you could rent your home for $6,000 per month, and you’re spending $2,600 on the mortgage, that would give you an additional $3,400 per month in income.

Is your home big enough to rent out a room (and would your husband’s disability allow it), bringing in additional income. Can you take advantage of the current job market and find a new job that will pay you more money? Do you have any other assets you can sell to help pay down your mortgage faster?

If you are eligible to start withdrawing money from your IRA or 401(k), you may consider taking some of that money out to pay for your expenses, but only enough for these expenses. You’ll pay federal and state taxes on these withdrawals but the withdrawals likely won’t bump you up into a much higher tax bracket, so you’ll pay less in taxes on those withdrawals and still leave money in the account to rise with the market or your other choice of investments.

If you’ve exhausted all other avenues and options, then taking money (either as a loan or a hardship withdrawal) from your 401(k) or IRA is probably where you’ll end up. But remember, once you pay off your mortgage, you’ll still have property taxes, maintenance, and the other expenses of homeownership.

It would be helpful to run these numbers by your financial advisor, if you have one. If you don’t, your company may provide this service as part of its financial wellness benefits. Ask your HR department for more information.

(Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through their website, bestmoneymoves.com.)

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