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Divorce settlement proceeds

Dear Dr. Don,
I just got a divorce, and will be receiving about $300,000 from a retirement fund. I will have to roll over that money to avoid taxes, but I was wondering if it would make sense to pay off my mortgage; which has a 6.85 percent variable rate, and a balance of $82,000. I am barely making ends meet, and paying that off would free up $800 a month. Or, should I just roll it over?
Rita Resume

Dear Rita,
Without knowing your age, your overall financial situation or your financial goals it's difficult to provide advice. Instead, I'll give you a few things to think about while you look for a fee-based financial planner, a tax professional, or both to assist you. The National Association of Personal Financial Advisors can help you find a fee-only planner in your area.

Cashing out enough to pay off the mortgage is worth considering. You may even be able to avoid the 10 percent penalty tax if the retirement proceeds are received as a lump sum under a Qualified Domestic Relations Order.

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Even if you don't have to pay the penalty tax, you will still owe income taxes on the amount received as a lump sum. The balance of the $300,000 can be rolled into your retirement account tax-deferred. The table below shows that you'll need to withdraw a lot more than your loan balance after considering taxes and the early distribution penalty, if applicable.

Loan balance
Marginal Federal income tax rate
28% (estimated)
Penalty on early distribution
Funds needed if subject to penalty tax
Funds needed with no penalty tax

The appreciation in your home's value over the years should be mostly tax-free with the current capital gains provisions on the sale of your home. So you're paying taxes upfront on the distribution from the retirement account, but the money can grow tax-free, at least up to the limits of the capital gains provision. You'll lose the mortgage interest deduction on your taxes, but save the after-tax interest expense on the loan balance while freeing up $800 a month.

If you go this route, don't let your spending on discretionary items use up all of the $800 that you've freed up in your monthly budget. Start a savings and investment plan to help you meet your future financial goals.

-- Posted: July 16, 2002

Read more Dr. Don columns
See Also
Checking out your investment plan
Retirement Checkup
Financial advice glossary
More Dr. Don stories

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