Raiding a 401(k) to pay mortgage isn't wise move

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Q: I am a 58-year-old male and I might be losing my job soon. I don't think I will be able to get another decent job, and my wife makes only $19,800 at her full-time job. I will be able to get health insurance through my wife's employer.

We owe $117,000 on our home and I'm thinking of removing $170,000 from my 401(k) to pay off the mortgage and cover the 401(k) taxes. I'm paying 5.63 percent on my mortgage, and doubt that I would make more than that if I kept investing the 401(k) money because I am a conservative investor. So getting rid of the mortgage seems to be a sensible strategy.

What are your thoughts? -- L.O., Grand Rapids, Mich.

A: I ran your question by a half-dozen financial planners and certified public accountants and none thought you should do this.

If you remove $170,000, all agreed that you would incur a large, unnecessary tax bill and cut yourself far short of the retirement money you are likely to need.

The strategy would give you the peace of mind for the moment, but in the long run it would put you in worse shape.

If, after the withdrawal, you are left with only about $300,000 in your 401(k), as you indicate, it would allow you to remove only about $12,000 to $15,000 a year during retirement. In order to keep from running out of money in retirement, financial planners say to remove no more than 4 percent to 5 percent of your nest egg per year.

So they suggest you leave the 401(k) intact, and keep growing the money in an account sheltered from taxes.

There is, of course, no hurry to do anything now. Maybe you won't lose your job. That's an important consideration.

Under federal 401(k) rules, people are allowed to take money out of 401(k) plans without penalty at age 55 if they lose their job, according to Steven Leventhal, a Bend, Ore., attorney. But if they don't get laid off, they can't touch the money until they are 59½.

So if you keep your job, that will be a relief, but Uncle Sam would show up at tax time and smack you with a 10 percent penalty for removing 401(k) money. Then, on top of that, you will be required to pay income tax on the $170,000. Mixed in with the pay you and your wife have received this year, you could jump a couple of tax brackets and perhaps double your taxes, says Warren McIntyre, a Troy, Mich., financial planner.

"Peace of mind is nice, but not worth the tax," he said.

Even if you do lose your job, McIntyre and other financial planners would not advise you to take $170,000 out of the 401(k) immediately. Instead, they suggest you can have the same peace of mind by knowing that later you can take money out in smaller amounts. If you can't find an adequate job, you could, for example, take about $8,600 out of the 401(k) each year you need it, McIntyre said.

That would benefit you in two ways. Because you would be out of work, or working part time, your income would be low. So -- even with the tax on your 401(k) withdrawals -- the tax bite probably would be lower than what you face now.

In addition, by leaving a larger sum of money in your 401(k) you could enhance the impact of investment returns.

Although you say you are a conservative investor and not likely to earn more than your 5.6 percent mortgage payment, Lincolnwood, Ill., financial adviser David Strulowitz said your mortgage is really costing you only about 4.2 percent once you figure in the tax deduction you receive for it. So compare your conservative investments to a 4.2 percent return -- not 5.6 percent, he said.

He said you can get a better return than you think. Even the average money-market fund is yielding 4.73 percent and some, such as Vanguard Prime Money Market, are over 5 percent, according to iMoney net.com.

Strulowitz encourages you to consider investing your money half in stocks and half in bonds.

If your investments provided a 7 percent return, you could double your retirement money in 10 years, he said.

Of course, any investment can decline in value and stocks do decline further than bonds. But a 50/50 combination tends to be fairly resilient. According to Ibbotson Associates, the worst downturn in such a combination since 1970 was 25.6 percent over 22 months, starting in December 1972. But nine months later, an investor had recovered completely. Over the long term, investing half in stocks and half in bonds has provided an average annual return of 8.4 percent.

John Scherer, a Madison, Wis., financial planner, notes that even though you might look at your mortgage payment as large now, when you go through retirement it will appear increasingly smaller as inflation pushes up the cost of everything else and your mortgage stays static.

He remembers his parents worrying about $135 mortgage payments in 1978. When they were spending $135 for their home in 1998, he said, "it looked like a joke." As you go 15 or 20 years into retirement you will want extra earnings from your 401(k) to pay the rising costs you can't control, Scherer said.

Meanwhile, in case you lose your job, start preparing now as best you can. Cut back on any expenses you can, pay down any non-mortgage debt, and try to build up an emergency fund.

It's also a good idea to apply for a home-equity line of credit at an institution that won't charge you any fees to do so. If you lose your job, it will be too late to apply. Don't use the line of credit, though -- think of it as an insurance policy. If you can't find a new job and need money in an emergency, you can tap your home equity temporarily.

For example, if you were having trouble making mortgage payments, or maybe had a $30,000 hospital bill, McIntyre said, you could borrow money on the line of credit. Then you could take $15,000 out of your 401(k) two years in a row and pay off the home equity debt. That way you would pay taxes each year on only $15,000 instead of $30,000 if you paid the bill off all at once.

Contact Gail MarksJarvis at gmarksjarvis@tribune.com or leave a message at 312-222-4264.

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