Should You Contribute to Your 401(k) or Pay Down Your Mortgage?
If you own a home, your mortgage is probably your largest debt and the biggest strain on your wallet.
Getting rid of it ahead of schedule is definitely tempting, but:
Is it a wise choice to pay off your mortgage when you have other savings you need to build, like your retirement?
If you're facing this dilemma and aren't sure what to do, take a look at why you should be investing your extra money in your 401(k) instead paying down your mortgage early.
You'll get a better return from your 401(k)
Compared to other types of debt, mortgages tend to carry a pretty low interest rate but when you're stretching it out over a period of 20 to 30 years you're not exactly getting off cheap.
If you're going back and forth between putting extra money towards your mortgage or funneling it into your 401(k), running the numbers makes the answer clear.
Let's say you take out a $200,000, 30-year mortgage loan at a rate of 4 percent.
Your payments come to about $950 a month and you'll hand over $143,000 in interest alone once it's all said and done.
If you tack on an extra $200 a month, that takes 8 years off the loan schedule and eliminates $44,000 in interest charges. That's some pretty decent savings, right?
Now, assume that you're making $60,000 a year and chipping in 6 percent to your 401(k). If you were to put that $200 a month into your retirement plan instead, you effectively increase your annual contribution amount to 10 percent of your pay.
2022 and 2023 Roth IRA Contribution Limits (based on income)
|Filing status||Modified adjusted gross income in 2022||Contribution limit for 2022||Modified adjusted gross income in 2023||Contribution limit for 2023|
|Single individuals||Less than $129,000||$6,000 ($7,000 if age 50 or over)||Less than $138,000||$6,500 ($7,500 if age 50 or over)|
|$129,000 - $143,999||Partial contribution||$138,000 - $152,999||Partial contribution|
|$144,000 or more||No contributions||$153,000 or more||No contributions|
|Married filing jointly||Less than $204,000||$6,000 ($7,000 if age 50 or over)||Less than $218,000||$6,500 ($7,500 if age 50 or over)|
|$204,000 - $213,999||Partial contribution||$218,000 - $227,999||Partial contribution|
|$214,000 or more||No contributions||$228,000 or more||No contributions|
|Married filing separately||Less than $10,000||Partial contribution||Less than $10,000||Partial contribution|
|More than $10,000||No contributions||More than $10,000||No contributions|
After 30 years, your nest egg would be worth $235,000 more, assuming a 7 percent annual return.
Even if you subtract the interest you paid on the mortgage, you're still coming out ahead to the tune of nearly $100,000 by padding your 401(k) instead.
Tip: If you can't make a huge jump in your 401(k) contributions right away, ask your plan administrator to automatically increase your deferrals by 1 percent each year until you reach your goal.
You need the tax deduction
One of the perks of owning a home is the ability to write off your mortgage interest on your taxes each year.
As of 2020, homeowners can deduct interest paid on first and second mortgages up to a total loan value of $1,000,000.
The limit is $375,000 for a married taxpayer filing a separate return.
Since deductions reduce your taxable income, claiming every one you can is crucial, especially if you're in a higher tax bracket.
When you pay your mortgage off early, you lose the value of that deduction. That may not seem like a big deal if you've got business expenses you can write off or you qualify for certain tax credits but it can be a problem when you start taking money out of your 401(k).
Even if that's still three or four decades away, it's something you need to think about now.
Unless you've been saving in a Roth IRA plan, your distributions are going to be taxable at your regular rate once you retire.
Changes to Standard Deductions in 2018
|Tax filing status||Standard deduction for 2017||Standard deduction for 2018|
|Married filing jointly||$13,000||$24,000|
|Married filing separately||$6,500||$12,000|
|Head of household||$9,350||$18,000|
If you're drawing money from a pension, Social Security, IRA or a part-time job, adding on distributions from your 401(k) could potentially push you into a higher tax bracket.
You'll dodge a 10 percent early withdrawal penalty as long as you're over 59 1/2 but the regular tax rates still apply.
Being able to claim the mortgage deduction can potentially offset a bigger tax bill if you expect your income to be higher in retirement than it is when you first bought the home.
Although the value of the deduction may be diminished as you pay the principal on the loan down, every extra dollar you can write off counts. Just keep in mind that you have to itemize to claim the deduction so you won't benefit if you normally claim the standard deduction.
Tip: Interest paid on home equity loans is also tax deductible but only up to the first $100,000 in loan value.
The home is not your forever home
The home you buy in your 20s or early 30s isn't guaranteed to be the same one you grow old in.
A lot can happen along the way, including marriage, kids and multiple job changes and as your needs adjust, you may find that the home you're living in just doesn't fit anymore.
One thing that won't change, however:
The need for a comfortable retirement fund.
Paying off your mortgage early really doesn't make financial sense if you're not planning to stick with it in the long haul.
Making the assumption that you're going to get the extra money you've been putting in back once you sell is a gamble. If your home's value drops for some reason, you've basically lost money on the deal.
You're still taking a risk when you invest in your 401(k) but there's the advantage of having time on your side.
It's a lot easier to see the value of your assets rebound when you've got 20 or 30 years before you need to tap it versus the relatively short time frame you're working with you're trying to sell a home.
Final verdict: Kill your other debt before the mortgage
Once you've reached the point where you're maxing out your 401(k) and saving in an IRA or Health Savings Account, that's the time to turn your attention to the mortgage.
That is, of course, unless you're carrying other kinds of debt that are more expensive.
If you're stuck with student loans, credit cards or a car loan, wiping them out takes priority over eliminating your mortgage for a few reasons.
With the exception of student loans, the interest on these debts isn't tax-deductible so you get no long-term benefit from letting them hang around.
Besides that, there's the interest to contend with.
If you owe $5,000 on a credit card at a rate of 15 percent and you're only making a 2 percent minimum payment each month, you're going to pay close to $3,000 in interest in the 79 months it'll take to clear the debt.
When you look at it that way, putting your early mortgage payoff on the back burner is the best money move.