Question and background:
What are the tax liabilities for retired people using 401(k) money to pay off a home equity line of credit?
My wife and I are on Social Security, our income from that is about $41,000 a year before paying for Medicare, gap insurance and her COBRA plan. We would like to pay off our home equity line of credit and need to know if it would cost us less in income tax if we took half of it this year and the other half next year or would it be the same if we took it all this year? The money would be coming out of our 401K. We would need about $81,000 total including the required 20% that is sent to the government direct. We currently reside in Porter County in the state of Indiana. We have no other income other than Social Security and our ages are 65 and 64.
Yes, it will cost you less in federal income tax to distribute half ($40,500) this year and half next instead of all ($81,000) this year. Taking it all this year will push some of your taxable income into the 25% federal bracket. Splitting in half over two years will push you no higher than the 15% federal bracket. Indiana has a flat 3.3% rate so there's no state advantage to splitting.
But it may be wiser to instead take 401(k) distributions over several years and pay off your HELOC that way. The reason is the impact on federal taxation of Social Security benefits. The feds tax SS based on a concept called "provisional income" and it's different than the standard tax brackets. (Like most states, Indiana does not tax SS.)
Provisional income = adjusted gross income + non-taxable income (like muni bond interest) + half of SS benefits
At $41,000 of SS and no other income, your "provisional income" is $20,500. For married filing jointly and provisional income:
- less than $32,000 -- SS benefits are not even taxable
- $32,000-$44,000 -- up to 50% of SS benefits are taxable
- over $44,000 -- 85% of SS benefits are taxable
So you're currently not paying federal income tax. And for 2015, you have roughly $11,500 of provisional income "room" to take a distribution without triggering federal tax on your SS benefits. Further, if none of your SS is taxable, then only the $11,500 distribution would be federally taxable and your standard deduction and personal exemptions will more than offset that. (Don't forget Indiana tax on the distribution.)
Then just wash, rinse, and repeat each year until your HELOC is paid off. Adjust the distribution as/if needed due to inflation increases in your SS benefits. Treat the above as a strategic tax idea and not a specific recommendation for you. Other considerations include:
- You may want to roll the 401(k) to an IRA and take distributions from there if you want to avoid the mandatory 20% federal withholding tax...particularly since it looks like you could structure distributions to not owe any federal tax.
- Be sure to assess the potentially negative impact of 401(k) distributions now vs. if you'd actually need the money later in retirement for other living expenses. You may be able to carry a HELOC balance and just pay the interest, but you can't create money out of thin air if you find yourself needing it down the road.
- Consider the potentially positive impact that taking distributions now will have on lower Required Minimum Distributions (RMDs) once you turn 70 1/2. Depending on the size of your retirement account(s), future RMDs may push you over provisional income thresholds into higher tax. Taking distributions now may reduce or even possibly eliminate that problem.
- Consider your current HELOC interest rate (cost of money to you) vs. the likely investment return you'd earn by keeping more in the 401(k)/IRA and paying down the HELOC more slowly. But also consider how your investments are currently allocated and the elevated valuations (and the real risk that represents) in most financial assets.
- Engage the help of a good fee-only financial planner as needed...one who genuinely specializes in retirement income, Social Security, and taxation matters. The tax and other savings can often pay for the advice many times over.
I hope that helps. Feel free to reach out with any questions.
[A version of this Q&A first appeared on NerdWallet's Ask an Advisor October 8, 2015]