Mortgage vs withdrawal with income tax hit for home purchase

Submitted by Vivid_Fox617 t3_10pyb51 in personalfinance

-I have a good bit of money saved up to purchase a new home, but not enough to pay cash. I would need an additional 200K or so to pay cash. -I have an inherited 401K that I am on year 3 of the 10 year emptying rule with -I am trying to figure out what the differences would be between getting a mortgage for the 200K or taking it out of that inherited 401K (which, keep in mind, i have to empty anyway so the 10% penalty doesnt apply) -Obviously I would take a big income tax hit by taking the 200K, but I want to know how to figure out EXACTLY how much (and for that matter, I would need to figure out how much to take out to equal 200K after the taxes -Let’s say I get the mortgage for 200K and pay it off in 3 years….so would my comparison be 36 mortgage payments vs the extra tax hit of the withdrawal option? -paying cash will also save me about 3-5K in closing costs

Am I thinking of this question right? How do I answer it? Not asking you to answer it, though feel free I guess, but asking how do I answer this question taking everything I should take into account into account

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BouncyEgg t1_j6msbh2 wrote

401k (assuming Traditional) disbursals stack on top of your income. Then ordinary income tax brackets are applied.

So…

Start with your income without the 401k distribution.

Enter it into an income tax calculator like this:

Write down your total Federal income tax.

Then start adjusting the income until you get an additional net post tax income of 200k.

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Gabagool-enthusiat t1_j6myd43 wrote

How much is remaining in the 401k and what is your current taxable income?

If the regular annual distributions are already pushing into the top tax bracket, it might not matter that you're pulling out 200k at once.

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PlumCrazyVee t1_j6mrtho wrote

The income tax on 200k would be 35%, so 70k plus state taxes. It will be worth getting the mortgage and paying it off over the next 7 years.

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yes_its_him t1_j6mtg27 wrote

Note that if it was 35% tax rate (which it might or might not be depending on other income and other taxes...) then to get 200K, OP would have to withdraw $307,692 to have $200K after tax.

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Vivid_Fox617 OP t1_j6mv66q wrote

Wouldn’t we need to quantify 7 years of mortgage payments and compare it against this tax?

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yes_its_him t1_j6mvmi9 wrote

Well not really. You are concerned about the 'overhead' on your principal. For the retirement distribution, that's the taxes. For a mortgage, that's the interest payments.

The principal matters as well, but you are going to pay that in either scenario, and ultimately you would be taking money from the IRA in any event.

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Vivid_Fox617 OP t1_j6mxkzu wrote

So we would want to quantify 7 years of interest payments and compare it to the extra tax

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yes_its_him t1_j6mycmm wrote

Basically yes, if we ignore time value of money.

6% of 200,000 would be about $12,000 annually. It's likely that it would take several years for that to work out to the extra tax from taking the money sooner, but that depends on a bunch of parameters.

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ghalta t1_j6nptiz wrote

To re-explain what the other response means for "time value of money"...

The extra tax would all be at once, right now, while the interest is paid over time. That means the interest you pay in year 7 costs you less in 2023 dollars thanks to inflation.

Meanwhile, presumably your remaining 401k balance continues to generate returns even as you draw it down. So, the 6/7ths of your mortgage balance you don't withdraw this year and instead let grow for a year, the 5/7ths the following year, etc., will go up in value each year, even if you just put it in an ultra-low- or no-risk investment product during that time.

These time effects on money converge, meaning the value of the money you have goes up over time, while the value of the money you owe goes down over time. Put them together, still ignoring any potential impact from bumping up your incremental tax rate, and the cost of 7 years of interest payments could be much less than simply calculating the interest due via spreadsheet.

Then throw in the potential for extra taxes if you liquidate the 401k all at once, and you might tip the scales over in favor of getting a mortgage.

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Vivid_Fox617 OP t1_j6mtdng wrote

How do you know what tax bracket 200k would put me in?

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yes_its_him t1_j6mt892 wrote

You are going to take out the money eventually anyway, so you want to find the incremental tax hit of taking it out sooner. That occurs because bigger distributions potentially are taxed at higher rates than smaller distributions due to tax brackets. To know this, you'd have to know your current tax bracket and what you would otherwise take out each year.

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FellowConspirator t1_j6nff1f wrote

Whatever you take out of the 401k would count as ordinary income and taxed that way. You are required to take money out of the 401k in the next 7 years anyway, and, assuming that your regular income is pretty steady, you'd minimize your tax impact by taking out 1/7th each year. Is that >$200K + tax (roughly $308K total)? If so, then definitely go the 401k route because you'll need to do it anyway.

If not, then you really just need to calculate the costs in either scenario. The mortgage is likely to be a very reasonable option unless the 401K balance is very high.

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nolesrule t1_j6msoam wrote

Since you already have to withdraw income from the inherited 401k, the question to ask is if the larger withdrawal will push you into a higher tax bracket. If so, then the extra added cost is the increase in tax rates on the added income. Keep in mind that adding $200k+ to your AGI will also push you into the Net Investment Income Tax if you are not already there (it kicks in at $200k single / $250k MFJ).

You would then compare that extra tax paid above your current marginal tax rate to the cost of the interest + closing costs related totaling out a mortgage. So for example if you are in the 22% bracket 10k below the top and the extra withdrawal pushed you into the 24% bracket, the extra tax cost would be 2% of 190k.

However, since you want the total tax cost to come from the withdrawal as well, you run into a bit of a problem, because taxes aren't flat, as noted above, so you can't use a recursive formula to figure it out.

My recommendation for getting these answers is just to run a pro-forma tax return using this year's tax software. Unless there is a major overhaul in tax law the results will be very similar to next years taxes, probably slightly high because there haven't been adjustments to the inflation-indexed numbers.

And don't forget state taxes if you have them.

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yes_its_him t1_j6mtpvb wrote

Just to clarify, NIIT applies to investment income, and retirement plan distributions are not considered investment income for this purpose. Other types of investment income could be affected though.

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Vivid_Fox617 OP t1_j6mthkx wrote

Net investment income tax doesn’t apply here I don’t think? Withdrawals from an inherited 401k are 1099R income

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nolesrule t1_j6mtx41 wrote

Not directly, but it applies to interest (including bank interest), dividends and and capital gains, so adding additional ordinary income can push any investment income into NIIT.

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nails_for_breakfast t1_j6n8q3r wrote

We're never going to know enough of the nitty gritty details of your personal finances to give you good advice on this. You need to hire a CPA.

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Vivid_Fox617 OP t1_j6nctq3 wrote

I’m less looking for advice and more for parameters I need to be thinking about and including in order to answer the question myself

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Vivid_Fox617 OP t1_j6ndfb0 wrote

I have asked a financial advisor who said gosh you should really talk to a cpa and a cpa who said gosh you should really talk to an advisor lol

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Imaginary_Shelter_37 t1_j6nqtlu wrote

You might also want to consider how the interest on a $200k mortgage may allow you to itemize deductions on your tax return rather than taking the standard deduction.

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