Dear Dr. Don,
I plan to retire in about four years at age 66. My home mortgage will have about 11 years remaining. Should I cash in my 401(k) and pay off my mortgage?
-- Jerry Jericho
Dear Jerry,
I think it's a great financial goal to plan to have your mortgage paid off prior to retirement, but I don't think it's such a great idea to cash in your 401(k) to reach that goal.
You want to preserve a measure of financial flexibility.
Cashing in the 401(k) has you taking a big tax hit all at once, which will put you in a higher marginal federal income tax bracket for that year. It also has you concentrating your investments into one investment -- your home. Sure, you should be able to get a home equity line or loan against it if you need funds, or even a reverse mortgage, but that puts you back into a mortgage.
If you're still contributing to the 401(k), you could reduce your contributions down to the limit of any company match and use the freed-up funds to make additional principal payments on the mortgage. You can also use the reduction in payroll taxes in 2011 toward additional principal payments. Chip away at the mortgage balance over the next four years while you're still working and see where things stand at retirement.
My rule of thumb is that it makes sense to prepay the mortgage when the after-tax return on your investments is less than the effective rate of interest on your mortgage. If you've dialed down risk in your retirement portfolio, you may be in a position where it does make sense to pay down the mortgage. Just don't do it all at once, and work with your tax professional or financial planner to time the distributions out of your 401(k) to minimize the tax impact.
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