Beware of Tax Hit on Large 401(k) Withdrawals

QUESTION: My husband retired, and our income has been reduced. I am 62 this summer, and I would like to use my 401(k) to pay off our mortgage. When would be the best time to pay off our mortgage with the 401(k) and not take a large tax hit?

ANSWER: Having a home paid off for retirement should be a top goal for everyone. When there's no mortgage payment due each month, it's much easier to get by on a fixed income.

If you had a large stash of cash that was not tied up in a retirement account, I'd say pay off the home as quickly as possible. But having money in a 401(k) is not the same as having a chunk of cash. The reason? You have a silent partner in your 401(k): the tax man.

The tax man has an interesting set of rules in that the more money you make in any one year, the larger the percentage of your 401(k) he wants. The federal income tax rates range from 10 percent to 35 percent. That means a withdrawal could be taxed as little as 10 percent or could be taxed as high as 35 percent.

The majority of Americans pay tax at the 15 percent tax rate. The rate jumps from 15 percent to 25 percent when a married taxpayer's taxable income (after all deductions) exceeds $59,400 ($29,700 for singles). 401(k) withdrawals that don't push your taxable income above that amount will be taxed at 15 percent. Withdrawals above that amount will be taxed at 25 percent or higher. Depending upon your income and the size of your mortgage balance, it may be best for you to pay your home off over the next few years.

If you take a large withdrawal from your 401(k) in one year, you may be paying 10 percent or more in unnecessary taxes to the tax man.

Before you do anything, run some tax projections to see how a 401(k) withdrawal will impact your taxes. You can purchase an inexpensive software program to run the calculations for you, or you can meet with a good tax planner. Once you can determine the tax hit, you can then make a wise decision as to the timing of your home payoff.

Scott Hanson, CFP, is a senior adviser with Hanson McClain, an investment advisory company and registered principal with Securities America, member NASD/SIPC.

Source: Scripps Howard. © 2004 Scripps Howard News Service. All Rights Reserved. Powered by YellowBrix.