401K Distributions (Taxes) vs Home Equity Loans (Interest)

[MichaelD180397]

This topic is cross-posted in the Retirement Forum

Hello group - 

Background: My wife and I have to decided to help our age-in-place plan by proceeding with some major renovations to our current home.  We anticipate $100,000 as the cost of the renovation which would take approximately 3 months and must be paid as we go.  We've got about $50,000 in the emergency fund, cash, and we take in just enough monthly via pension and social security to pay our expenses.  We have over a million in the 401K which we haven't tapped yet.  Looking locally I've found a Home Equity Line of Credit with no upfront costs at an excellent rate of prime - 0.5%.  That would be 2.75% right now.

The question:  Is it wiser to take a distribution of $130,000 from the 401k (state and federal taxes) or borrow the $100,000 at 2.75% and pay it down over 10 years, thus avoiding a substaintial outlay from the 401k all at once.

As always, your thoughts will be appreciated and considered as thoughts only and we will make our own decision and take total responsibility for the consequences.  Thanks gang.

[fffred]

@MichaelD180397 

My first reaction is that I would go with the home equity loan at this time. Bear in mind that I am not one to get myself in debt so it may seem that taking the HEL would go against my grain (see below*).

That loan rate is very low, historically low. Of course, earnings on bank and bond interest are laughably low. But inflation is also running relatively low. There is some cost to the loan as interest you will pay, as you say. The counterpoint is there will definitely be cost as well to drawing from your 401K (are you able to draw from that without early penalties or other costs, only paying income tax on it?)

You can quantify both costs, even the tax on the 401K. This might provide an exercise for a long afternoon with your calculator and reference to IRS forms (or a visit to an accountant...for a fee). The taxes on the draw will depend on what other income you have (as the marginal tax rate might vary). And in fact, it might be advantageous to draw the amount over two tax years in order to minimize the tax rate.

(it occurs to me now that you can probably even use something like TurboTax on the Web to run through several scenarios of taking various amounts from the 401K and see how that affects your taxes...just don't end up submitting these draft scenarios to the IRS accidentally).

By taking the HEL now you can proceed right away without having to wait for funds to transfer, etc. And without being too distracted by the tax situation. You might find that when the projects are complete and you're paying the loan that you'd feel better by paying it off...later in this year. So at that time you might consider drawing half of the loan amount from your 401K in this tax year (2021) and then the other half in the following year; so you would pay down the loan in two lump sums (along with the normal payments). Yes, this might be the sweet spot.

But I would certainly spend that afternoon, or an hour or two, trying to guesstimate the taxes you'll pay on drawing the full $100K now. And then compare that to the interest you'll need to pay on the loan.

One more thought. It's nice to have my home as paid-off. But it's also nice to have cash in the bank to pay for regular living expenses and for any urgent needs that can come up. If I had that $100K project I would consider the same thing...taking that HEL versus drawing down my cash.

-Good luck!

(*)  my background: I have paid my credit cards off in full every month since around 1985, and not gone overboard in loans for cars or homes. Last two cars were bought with cash, and my mortgage was paid off 3 months before I retired 3 years ago.

[fffred]

@MichaelD180397 

Putting some numbers to this, let's say that for 2020 you have an adjusted gross income of $38,000 (I have no idea, I'm just plugging this into my "tax" spreadsheet). I assumed standard deduction of $26,100 (what it is for my wife and I; I'm older than 65, she is not) with taxable income of $11,900. This puts the hypothetical example in the 10% marginal tax rate and your income tax is $1,190.  (I assumed no other dependents)

Simply adding $50,000 to this income (draws from 401K and IRAs are treated as regular income) results with taxable income of $61,900 with tax = $7,033; marginal tax rate = 12%.

Add the full $100,000 to the original income example results with taxable income of $111,900 and tax of $16,198. Marginal tax rate is 22%

Compare the first month's interest on the$100,000 at 2.75%, the interest is around $229.17. Twelve times that if you only paid the interest for the first year. You can use an online calculator to amortize the amount, over whatever duration you want, and obtain the total interest paid.

So you might want to consider taking out cash from your 401K up to the ceiling of, say, the 10% or 12% marginal tax rate. Getting into the 22% band gets expensive. And do this over 2 or more years.

Edit to add:   of course, eventually you will (most likely) be drawing from the 401K for living expenses. So this money will get taxed anyway. The key is to minimize your tax burden across the years.

[MichaelD180397]

Excellent points @fffred . I'm afraid there is no escaping the 22% trap but I'm building my spreadsheet now trying to determine the real difference in cost between the taxes paid vs the interest on the loan. Your suggestion to parcel out the distributions from the 401k is a good one.  Our pension and social security income does leave some room for a modest withdrawal and still remain below the $81,050 22% bracket.  I wonder if it would be simpler to pay someone who is really good at this to figure out for me.  My brain pan has a leak I think.  Thanks

[fffred]

@MichaelD180397 

(Editing to add:  see https://www.irs.gov/pub/irs-pdf/p915.pdf, Worksheet 1 for percentage of Social Security that may be subject to income tax)

Gail provided the links for Medicare premiums above. For Part B, assuming you file "married filing jointly" the highest income before IRMMA is $176,000. So this is likely not an issue for you.

For Part D the document at link says "If you have a higher income, you might pay more for your Medicare drug coverage. If your income is above a certain limit (... $174,000 if you’re married and file jointly), you’ll pay an extra amount in addition to your plan premium (sometimes called “Part D-IRMAA”)." So, a similar limit  ($174,000) and it likely is not an issue for your determination of withdrawing an amount "X" from your 401K so that your income remains in the 12% bracket (going a bit into the 22% bracket won't a killer.

Regarding taxable Social Security. Well, I was going to wave my hands and say "not an issue". But I plugged some dollar amounts into my spreadsheet and it looks like it's pretty easy to enter into the territory of tax on SS benefits. Especially if you will be near the 12% zone ceiling with the largish 401K withdrawals. Just for instance, it might be that roughly 1/3 to 1/2 of the SS benefits might be taxable --which then forces you to lower the 401K withdrawal to keep below the 12% ceiling. So this can take some creative work with pencil and paper or an electronic spreadsheet. 

Looking at this briefly--but a bit further than I did at first--with my spreadsheet; and of course the numbers are highly dependent on SS benefits and other income, I can certainly see that up to 85% of the SS benefit might be taxed [edit to add:  and 85% is the maximum proportion of the SS benefit that can be subjected to income tax], even with the total taxable income at the top of the 12% marginal tax rate band. I guess it is for this reason that I've pretty well accepted that I myself will be paying income tax on 85% of my SS benefits until very late in the game.

So in this case (partial withdraw from 401K):  no IRMAA for Medicare. But you may have to pay income tax on up to 85% of your SS benefit. And you might only be able to take out around 1/3 of that $100K without bumping up into the 22% bracket.

Alternative is:  Taking out the full $100K to pay cash for the work would surely result in IRMAA on Medicare and also tax on 85% of SS benefits. And the 22% tax rate on the bulk of the $100K.

Good luck!

[GailL1]

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@fffred wrote:

Add the full $100,000 to the original income example results with taxable income of $111,900 and tax of $16,198. Marginal tax rate is 22%

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Depending upon the OP's actual numbers in income - there could also be some other unintended consequences.

1.  IRMAA  - higher monthly premiums for Part B based on income. 

Medicare Part B Cost 2021 

and higher Part D monthly premiums too

Medicare.gov - Monthly Premiums for Drug Plans 

2.  Those marginal tax rates are probably gonna rise - maybe sooner than later.

[MichaelD180397]

@GailL1  - Well done.  I had completely forgotten about the medicare income thresholds.  A $100,000 withdrawal from the 401lk, would still have us below the $176,000 threshold where the increase kicks in from $148.50 to $207.90.  Alas, we've already been hit by the tax torpedo for our social security benefits.  Thanks Gail

[fffred]

@GailL1 

@MichaelD180397 

Absolutely right, Gail. It was on my mind too to mention that if someone in this situation is collecting Social Security benefits then any additional income may drive more of the SS benefit to be taxed (or to become taxable in the first place. But for that I have to break out a different spreadsheet.  😉

Thanks for commenting on those additional issues!