Financial advisors are often asked, “Should I use my 401k to pay off the house?”  The answer should always be, “it depends.” A good financial advisor will advise clients to get out of debt, but liquidating a 401k can have expensive consequences.

Retirees who have seen their 401ks or IRAs shrink over the last year may regret the decision to have stayed invested rather than pay down debt.  But before beating yourself (or your spouse) up over a poor choice, consider the effects of liquidating a retirement account.

When you make a withdrawal from a 401k or traditional IRA, every dime is taxable as income for that year.  State and federal graduated income tax rates climb with your income.  Therefore when you withdraw money from a retirement account, you bump yourself up into a higher tax bracket.  But really, how bad could it be?  The combined highest Federal and State tax rate is 45.3%.  Someone who has done well at putting away will lose nearly half their savings to the government should they liquidate their retirement account in one year.  Liquidate before age 59½, and you’ll lose over half your account after the additional 10% early withdrawal penalty is tacked on.

Before giving away your retirement, consider a different strategy.  If you can’t afford (or don’t want) risk, invest your retirement funds in treasury securities, FDIC insured CD’s, or other cash equivalents.  This will allow you to earn a small but safe return; and although you may be paying more on a mortgage than your investments are paying, after the effect of taxes you will likely be much better off.

It is not necessarily wrong to go against what makes the most sense mathematically today.  The experts have been wrong before, and the equation would need recalculating should taxes return to Jimmy Carter Era rates. 

Whatever you do, be sure you’ve considered every option.  Consult a qualified professional for your specific situation.  A wrong decision on what to do with a 401k will cost much more than you will pay for the services of a professional.

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