If you’re at that point where you want to do anything to get out of debt, you might consider selling your investments. More specifically, using your retirement to pay down debt. We made the decision to use a $25,000 IRA withdrawal to pay off the mortgage. Do you think we’re crazy?
(Josh is a freelance writer during the day, and chases his two small children in his free time. He’s here to tell his debt free story — including why he used an IRA withdrawal to pay off his mortgage.)
There are many different mortgage payoff strategies you can use that eliminate your monthly payment without tapping into your IRA or 401k to pay off debt. However, there are several reasons why you might decide to follow a similar path to ours.
I’ll be the first to say that you should only use your retirement money to pay off the mortgage after you have used non-retirement savings. So if you contemplating using your retirement to buy a house or pay off the mortgage, there are a few things you should know:
- Early IRA withdrawals are subject to a 10% penalty
- It’s possible to withdraw up to $10,000 penalty-free
- Traditional IRA withdrawals are also taxed
Before you make a snap decision to trade your retirement nest egg for financial freedom, you need to evaluate your motivation to get out of debt and make the best financial decision for your circumstances.
Our Mortage Payoff Dilemma
Before I share the ins and outs of early IRA withdrawals, I’ll give you some background about why we decided to use our retirement funds to pay off our mortgage early.
One of the main reasons why we paid off our mortgage early was all the life changes we’ve experienced in the past five years.
Some of our most notable changes include:
- Having two children
- Changing to a family-friendly career
- Taking a 50%+ pay cut with the career change
Although we never missed a monthly payment or went hungry, we went from making $80,000 annually as a salaried employee to earning $35,000 of variable income with our career change as we’re both self-employed. Although we only earned $20,000 the first year I changed careers because I didn’t have a reliable client base yet.
Memories from the 2008 Great Recession were still on our minds as we saw family members and co-workers struggle to make ends meet when they were laid off. Our mortgage payment alone was almost as much as our other monthly expenses combined!
Because my wife and I both earn a variable income and our occupations aren’t necessarily “recession-proof,” being debt-free before the next recession comes is a large priority for us.
Besides our variable income, our motivation to get out of debt is also saving thousands of dollars in interest payments. After seeing how much money we could put in our bank account instead of paying mortgage interest, we started to think seriously about paying our entire mortgage off early.
We had the cash to pay off the remaining $40,000 balance, but it meant withdrawing $25,000 from our individual retirement accounts (IRA). Over the course of three months, we decided to pay off our remaining balance ASAP.
Today, we’re 100% debt-free!
What You Need to Know About Early IRA Withdrawals
Whether you have a Traditional IRA or a Roth IRA, you can make penalty-free withdrawals once you turn 59 ½. With a Roth IRA, your first contribution must have also occurred at least five years before. So if you open a Roth IRA on your 58th birthday, you must wait until you turn 63 before you can make your first penalty-free withdrawal.
When you make an early withdrawal, you will have to pay a 10% penalty unless the withdrawal is for one of these qualified distributions:
- Pay for a first-time home purchase (up to $10,000 lifetime)
- Qualified education expenses
- Unreimbursed medical expenses or health insurance
- Become disabled or pass away
Each deduction has specific rules, so I encourage you to review the current IRS early withdrawal policy or speak with a tax professional as well.
Since this article primarily focuses on paying off your mortgage, you can technically withdraw $20,000 penalty-free for your home purchase if you and your spouse both withdraw $10,000 from your individual retirement account. Just make sure you do it within 120 days of your home acquisition date to qualify for the deduction.
Unfortunately, we waited a couple years to withdraw from our retirement accounts, so we have to pay the 10% early withdrawal penalty on our withdrawals.
Early Roth IRA Withdrawals
Roth IRAs are slightly more complex than Traditional IRAs when it comes to early withdrawals. If your account has been open for less than five years, the earnings you withdraw can be subject to taxes (not the 10% early withdrawal penalty) even if you qualify for one of the qualified distributions.
If your first Roth IRA contribution occurred at least five years ago, your investment earnings are not subject to taxes.
Because you fund Roth IRAs with post-tax dollars, you will never pay taxes on your original contribution amount. As long as you withdraw less money than your total contribution amount, you don’t have to worry about paying taxes thanks to the Roth IRA ordering rules that distributes contributions and conversions first.
Most brokerages automatically withhold 10% of your early distribution to cover the early withdrawal penalty. If you withdraw $10,000, you can only expect to receive $9,000.
Early Traditional IRA Withdrawals
If you plan on making an early Traditional IRA withdrawal, you will need to pay taxes on the entire distribution amount because these accounts are funded with pre-tax dollars.
When you don’t qualify for one of the penalty-free early distributions, you also need to pay the 10% early withdrawal penalty too. For the same $10,000 withdrawal, you can anticipate only being able to spend $7,000 once your brokerage withholds 30% for taxes and penalties.
The Best Way to Use Your IRA to Buy a House
Using our IRA to buy our house wasn’t in our thought process when we bought our house three years before. We could have maximized the $10,000 tax credit and paid even less in mortgage interest.
The “right” way to make early IRA withdrawals to buy a house is following these steps:
- Withdraw from a Roth IRA account that’s at least five years old
- Make the withdrawal within 120 days of your house acquisition date or during the construction process
- Only withdraw up to $10,000 from your Roth IRA and your spouse’s Roth IRA
Following these three steps means you can make an early IRA withdrawal that’s tax-free and penalty-free.
If you only own a Traditional IRA, your first $10,000 in withdrawals can also be penalty-free, but you still need to set money aside to pay distribution taxes.
5 Reasons Why We Used Retirement Funds to Pay Off Our Mortgage
I’ll be honest, many people who know anything about early IRA withdrawals think we are a fish with three eyes. IRAs and 401ks are for retirement after all, and Uncle Sam does his best to deter you from making early withdrawals. With mortgage rates at near historic lows, the long-term income potential from investing is higher than the money we saved in interest payments.
But, I’ll share a few reasons why withdrawing $25,000 early from our Roth IRAs was an ideal decision for our circumstances.
1. We Wanted Peace of Mind
The #1 reason why we decided to pay our mortgage early was for the financial peace of mind. Yes, we have less money to earn long-term compound interest, but being debt-free was more important to us given our personal situation.
When we made the decision to pay off our mortgage, we had a $35,000 annual income. Two years before, my career change took longer than expected and it took eight months for me to earn a steady income. Not having to make a $600 minimum monthly mortgage payment is an immediate $7,200 pay raise for us.
2. We Were Debt-Free Before
This isn’t the first time we are debt-free. Before we became proud homeowners, we were debt-free for two years. During this time, we squirreled away every spare dollar to make a sizeable down payment for our house.
Today, my wife and I are both self-employed and earn a variable income. Since we’re closer to a recession than we care to admit, we want to “recession proof” our finances as much as possible. Both of us have family members that either switched career fields during the 2008 Great Recession or extended their retirement date to make ends meet.
We can’t predict our future employment or health situation, but we can control our monthly payments today.
Because we were debt-free when we first got married, paying off our mortgage was a huge priority to us because we knew the benefits of not having a monthly payment.
3. We Still Have Money in Our IRA
Before we sold our first investment, we also said we wouldn’t make an IRA withdrawal if it meant spending our entire retirement nest egg. In reality, we only withdrew a quarter of our retirement account. And, we still have a fully-funded emergency fund that covers six months of living expenses.
One of the typical clichés against paying off your house early is that “you can’t eat your house!” We still have plenty of liquid cash to pay a surprise expense or survive a surprise job layoff.
4. We Used Our Non-Retirement Money First
Before we agreed to withdraw from our retirement accounts, we used our non-retirement savings first to minimize our tax bill. Because the 2018 capital gains tax rate for married couples earning less than $77,200 is 0% for long-term gains and 12% for short-term gains, you should always consider using your non-retirement investments to pay off debt first.
Our house cost $140,000 and we made our initial payments with our non-retirement savings and investments first. We made lump-sum payments from our savings accounts and taxable investment accounts first. Between these large payments and two years of double monthly mortgage payments ($1200 principal payments instead of $600), we whittled our remaining balance down to $25,000 in early 2018.
At this point, we were comfortable withdrawing from our retirement account to pay off our remaining balance.
5. We’re Debt Free!
Our mortgage was our last debt payment. Over the past decade, I had already paid off roughly $80,000 in consumer debt, excluding our mortgage. Not having to make yet another monthly payment is a huge relief.
Finally, I’m in my early 30s and my wife is in her late 20s. Not many people in our age group can say they are entirely debt-free! Instead of paying for yesterday, we can focus on saving for tomorrow.
If You’re Considering Using Retirement Money to Pay Off the Mortgage…
Using your retirement account should never be your first option to pay off debt because of the potential tax and early withdrawal penalties. If you decide to make early IRA withdrawals, you should ask these questions first:
- Can I use any cash savings or non-retirement investments first?
- What are the tax implications for an IRA withdrawal?
- Will I still have most of my IRA balance left?
- Is the immediate peace of mind worth it?
Everybody will take a different journey to achieve this goal. If your journey includes making an early IRA withdrawal, the peace of mind can be well worth it.