Dear Dr. Don,
My wife and I are in our early 50s and worried about stock market volatility. We'd like to "batten down the hatches" by paying off our mortgage early with proceeds from my thrift plan, which is funded with after-tax money and worth $252,000 as of late January. Roughly half of it is composed of company stock contributed by my employer. (I know! I'm overexposed!)
To access this money, I would have to pay a 10 percent penalty and taxes on earnings only. The plan also will suspend any new contributions for one year.
I'm not sure how much I'd have to take out to net $130,000, which is the amount we owe on the mortgage. We have 25 years left on the mortgage with a 6 percent fixed rate. There's no way we want to be making mortgage payments beyond eight years from now.
In addition, I have a cash balance pension plan valued at $116,000. My wife has about $125,000 in her retirement accounts, which were funded with pre-tax money.
We figure we can pump the $1,265 mortgage payment into an emergency account, diverting some of it into a taxable investment account.
Would this be a wise move?
-- Prudent Paul
I understand your trepidation about the stock market, but I don't recommend cashing out your retirement savings to pay off the mortgage. You're describing a situation where you'd pay a 10 percent penalty to access the funds.
Paying 10 percent to get out from under 4 percent to 5 percent (after-tax) debt -- not to mention any taxes you'd have to pay on the investment earnings -- just doesn't make sense.
My general rule of thumb is that you sell off investments to pay off a mortgage when you expect to earn less on the investments then you pay on your mortgage -- using after-tax numbers for comparison.
For all but the most conservative investors, and assuming you can use the mortgage interest deduction on your taxes, it doesn't make sense to prepay the mortgage.
I asked John McFadden to weigh in on your situation. He is the Robert K. Clark chair in executive compensation and benefit planning and professor of taxation and pensions at The American College in Bryn Mawr, Pa. Here are his thoughts:
"As the questioner
indicated, the tax treatment of this withdrawal
is not very favorable. If he happens to have
any pre-1987 contributions to this plan, they
can be withdrawn first on a tax-free basis --
but there's probably not much pre-'87 money
there, if any.
"Post-1986 money comes out with the basis allocated ratably -- that is, part of the distribution is taxable and part is a tax-free return of basis. You need a good current statement of the account to determine the tax hit on a withdrawal. Some smaller plans don't provide very good participant account statements.
"Looking at this situation from an outside adviser's perspective, I'd say that the biggest issue is to get some diversification in the employer-stock holdings. I'd have to see the plan document to determine if this would be possible."
If you don't like the market, review and re-evaluate how you are invested. As Mr. McFadden said, that's especially true with the concentrated investments you have in your company's stock. To have all your human capital (labor) and a large part of your financial capital invested in the same firm is a big risk.
Review the plan statements to see what options you have for diversifying out of your company's stock. IRS Notice 2006-2007,
"Diversification Requirements for Qualified Defined Contribution Plans Holding Publicly Traded Employer Securities," may be helpful in understanding these options. Work with a financial planner and a tax adviser to minimize the tax impact of any actions while reviewing your investment allocation.
In your early 50s, you're much too young to cash out retirement savings to pay off the house. If you want the house paid off in eight years, work on making additional principal payments but leave the retirement accounts alone.