Mortgage Refinance Taxing With 401(k)

Dear Dr. Don,

I have a rather convoluted question or rather several questions that branch out from one question. We have a mortgage with a loan balance of $245,000 on a home valued at $265,000 resulting in a monthly private mortgage insurance, or PMI, of $130. Our mortgage annual percentage rate, or APR, is 6.87%. We have $40,000 in a 401(k) account.

Would it behoove us to withdraw the 401(k) money, refinance at a lower rate with no PMI, and take the savings on the mortgage payment to rebuild the 401(k) balance? This also would reduce our mortgage term from the current 25 years remaining to 20 or even 15 years.

-David Denouement

Dear David,

A 401(k) account held with your employer isn't a piggy bank you can crack open and raid. While some plans offer in-service withdrawals, it's not common. The 401(k) plan may have loan provisions allowing you to borrow against the plan, but it isn't required to have a plan loan option.

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Typically, the loan option has to be considered first before considering a hardship distribution described by the Internal Revenue Service as a distribution required because the plan participant has an "immediate and heavy financial need." Similarly, the plan isn't required to allow hardship distributions. Talk to your plan administrator about the availability of in-service withdrawals, a loan program and/or hardship distributions. Employer contributions to the plan may not be eligible for a hardship distribution.

Even if the plan does offer hardship distributions, the IRS is pretty stringent about what qualifies as a hardship distribution. Getting out from under a PMI payment doesn't strike me as an "immediate and heavy financial need." But it isn't my call to make; it's the plan administrator's.

Assuming you have good credit, a cash-in mortgage would let you get out from under the PMI payment and capture today's low mortgage interest rates. To do that in refinancing would require you to bring about $33,000 to closing, over and above the closing costs associated with the mortgage, as shown in the table below.

Cash-in mortgage breakdown
Appraised value	$265,000
Required equity	$53,000
Existing equity	($20,000)
Cash-in at closing	$33,000

That's because a bank will only lend 80% of the home's appraised value without requiring PMI. Assuming a mandatory 20% withholding rate for federal income taxes on the 401(k) hardship distribution, you would only net $32,000 when cashing out the $40,000 in your 401(k). If we assume $4,000 in closing costs, then you're at least $5,000 short of having the money you need to do this cash-in refinancing. You'll need to find another source of funds to supplement the distribution in order to make this work.

I'm not a huge fan of people raiding their retirement accounts with the promise they'll rebuild them with future savings. Yes, you can make the math work, but you have to have the financial discipline to actually replenish the savings. Do you truly have that discipline?

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