Tax Consequences of Paying Off Home with 401(k)

Dear Tax Talk, I am soon to be relocated within my company to a new region of the U.S. I want to keep the home I currently reside in. My payoff is $227,000. I would need to withdraw $116,000 from my 401(k), in addition to other resources, in order to pay it off. I have 12 years left on my current home loan. Total interest savings over the next 12 years would be approximately $42,000.

Paying the house off will remove that mortgage payment, making it easier for me to afford a mortgage on a new home in my new location. Should I accept the early withdrawal penalties and pay off the house? I plan to use the existing home as a rental when paid off. The home currently appraises for approximately $325,000. -- J.D.

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Dear J.D., Consider the tax costs of paying off your home with a 401(k): You are going to need to do some calculations to help determine if withdrawing $116,000 from your 401(k) is a good decision.

While tapping into retirement plans may seem to be a good idea, not only is the income going to be taxable to you, but you may be subject to an additional 10 percent penalty if you are under the age of 59 1/2. As you can see, the IRS really wants you to keep that money for your retirement years.

Consider these tax costs when making your decision:

How much additional tax will you owe if you withdraw the money from the 401(k)? You need to work on a "tax projection" of what your tax liability will be once you add in the income -- and don't forget about the 10 percent additional tax, if that will apply. Keep in mind that there are certain tax benefits that phase out once your income exceeds certain levels, and they may be affected by this income. These may include, for example, education-related tax benefits, medical expenses, employee business expenses, rental losses, etc.
If you have lived in your current home two of the past five years, you may qualify for excluding $250,000 ($500,000 for married couples filing jointly) of capital gain if you were to sell it. By permanently converting it to rental property, you will forgo that tax benefit in the future if you sell the property and no longer meet the requirements for a home sale.
You need to be sure you understand the passive activity rules for rental properties once you convert your current home to a rental property. If your non-rental income is too high, you may be limited on losses you can claim.
Additionally, managing a rental property from afar is something you will need to take into consideration. You may need to hire a management company to assist with the inevitable issues that come up with your tenants.

Thanks for the great question and all the best to you in your new workplace.

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