If you have money in mutual funds, using some of it to pay off debt, especially debt with high interest rates, might seem like an attractive option. But cashing in your mutual funds isn’t always the best way to become debt-free, and, depending on how you hold those funds, you could end up with a big tax bill.
Here is what you need to know before you sell mutual fund shares to pay off debt.
Key Takeaways
- Cashing out mutual funds may not be the best option for repaying debt.
- You will owe capital gains tax on mutual funds that you sell at a profit from a taxable account.
- Cashing out mutual funds from an IRA or other tax-advantaged retirement account could trigger income taxes and penalties, depending on whether it’s a traditional or Roth account.
- Withdrawing money from investments to pay off debt also means missing out on future growth in those accounts.
Downsides of Cashing Out Mutual Funds To Pay Off Debt
If you aren’t planning to use the money that you’ve been investing in mutual funds for any particular financial goal, then why not withdraw it to pay off credit cards, student loans, or other debts? After all, eliminating debt now can free up more money in your budget that you can use to invest later.
However, there are two major drawbacks to cashing out mutual funds to pay down debt. The first is taxes, the second is the potential impact on your long-term financial situation.
The Tax Consequences
If your mutual funds are in a taxable account, you’ll owe capital gains tax if you sell shares at a profit.
Shares you’ve owned for one year or less are subject to the short-term capital gains rate, which is the same as the rate on your ordinary income. Depending on your total taxable income, that could be anywhere from 10% to 37%.
Shares you’ve held for longer than a year are subject to the more favorable rates on long-term capital gains—0%, 15%, or 20%, again depending on your income.
If you hold mutual funds inside an individual retirement account (IRA), you can avoid capital gains tax. If it’s a traditional IRA, however, you’ll be subject to income taxes on the amount you cash out plus a 10% early withdrawal penalty if you’re younger than age 59½.
With a Roth IRA you can avoid both income taxes and penalties as long as you’ve had the account for five years and have reached age 59½. Otherwise, you’ll face a 10% penalty. You can withdraw your contributions to a Roth, but not the earnings on the account, at any time, tax-free.
The Long-Term Consequences
Aside from the tax implications of selling mutual funds to pay down debt, it’s also important to consider how it can affect your ability to build wealth.
Note
By selling off mutual funds, you lose their potential for significant growth over time, especially if you have been reinvesting dividends to automatically buy more shares.
In addition, you’re only allowed to contribute so much to an IRA each year, so you won’t be able to make up for your withdrawals later.
Other Options for Paying Off Debt
Cashing out mutual funds isn’t the only way to pay off debt. Other methods you might use to reduce your debt load include:
- Refinancing your existing loans at a lower interest rate, such as through a personal loan
- Consolidating credit card debts onto a balance transfer credit card with a low introductory rate
- Taking out a home equity loan to consolidate debts
- Selling vehicles or other non-investment assets that you own but don’t need and applying the proceeds to your debt balances
If you’re struggling with debt repayment, you might consider some additional options, such working with a nonprofit credit counseling agency to create a debt management plan for paying off what you owe, possibly at a lower interest rate overall. Under such a plan, you make a single payment to the counseling agency, which then distributes the money among your creditors.
Can You Use a 401(k) Loan To Repay Debt?
A 401(k) loan can be an option for repaying debt if your employer’s plan allows it. However, if you leave your job, you may have to repay the loan in full within a short period of time. If you’re unable to pay it off, the entire amount could be treated as a taxable distribution.
How Much Tax Will I Pay if I Cash Out My Mutual Funds?
That depends on a variety of factors. When you make a withdrawal from a mutual fund that is in a taxable account, you’ll owe taxes based on how long you’ve owned those shares. Profits on shares held a year or less are taxed at the rate for short-term capital gains, which is the same as the rate on your other income and might be as high as 37%. For shares held longer than a year, the rate will be 0%, 15%, or 20%. With tax-advantaged IRA accounts you’ll owe income tax if the account is a traditional IRA but may be able to avoid any tax if it is a Roth IRA.
Can I Withdraw Money From a Mutual Fund at Any Time?
You generally can withdraw money from a mutual fund at any time without penalty. However, if the mutual fund is held in a tax-advantaged account like an IRA, you may face early withdrawal penalties, depending on the type of account and your age at the time.
The Bottom Line
While becoming debt-free is a worthy goal, using the money in your mutual funds to pay off debt has some serious downsides. You may be better off if you can leave your mutual funds untouched and dedicate more of your current income to debt payments.
Read the original article on Investopedia.