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 is not 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 a Roth 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.
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 ways you might be able 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 can generally 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.
FAQs
Key Takeaways
Should I sell mutual funds to pay off debt? ›
So, if you're wondering whether to pay off debt or save for the future first, the answer is always pay off your debt. Investing while you're in debt is a zero-sum game. Any money you might earn from your investments is pretty much canceled out by the interest you're forced to pay on your debt.
When should you cash out a mutual fund? ›
However, if you have noticed significantly poor performance over the last two or more years, it may be time to cut your losses and move on. To help your decision, compare the fund's performance to a suitable benchmark or to similar funds. Exceptionally poor comparative performance should be a signal to sell the fund.
Is it good to withdraw profit from mutual funds? ›
Should you withdraw your profits from mutual funds? The simple answer is 'No' until your goals are not fulfilled. Mutual funds have different types such as equity, debt, and gold. And based on your time horizon you should invest in different types of mutual funds.
When should I exit debt mutual funds? ›
If you are looking at something where it is a target maturity fund or a medium duration or a long duration fund, then definitely you would want to wait out for the entire period of the term of that particular fund because of the kind of bonds that they have invested in because if you wait out for the entire duration of ...
How much tax will I pay if I cash out my mutual funds? ›
Short-term capital gains (assets held 12 months or less) are taxed at your ordinary income tax rate, whereas long-term capital gains (assets held for more than 12 months) are currently subject to federal capital gains tax at a rate of up to 20%.
Should I cash out investments to pay off debt? ›
Generally speaking, you want to try to avoid selling stocks to pay off debt. But in some cases, simple mathematics pushes the needle in that direction. For example, if you have a lot of debt but it's at a 0% interest rate, there's really no hurry to get it paid off.
What happens to mutual funds if the market crashes? ›
However, during a market crash, stock prices come down. This, in turn, pulls down the performance of mutual funds holding these stocks. Companies, too, face a tough time with their operations taking a hit, and it takes time for stocks to recover. Performance improves only when stocks recover lost ground.
Should I withdraw my mutual fund before recession? ›
Keep earning money
This may seem obvious, but it's best to avoid withdrawing large amounts from your portfolio during a recession. When stock values have declined, selling shares to cover everyday living expenses can meaningfully eat into your portfolio's long-term growth potential.
What is the best way to withdraw money from mutual funds? ›
Utilizing a Broker or Distributor
If you invested through a broker or distributor, you could withdraw money from a Mutual Fund plan through them. Contacting your broker and requesting a withdrawal are options. You must complete and submit a withdrawal request form if you want to withdraw offline.
Mutual funds are liquid assets, and as long as you invest in open-end schemes, be they equity or debt, it's easy to withdraw your investments at any time. Moreover, there are no restrictions.
Should you stay invested in mutual funds? ›
It is, however, important to remember that mutual fund investment gives good returns when you stay invested for a long period. This is vital to keep the impact of volatility to minimum.
What is the main disadvantage of a mutual fund for an investor? ›
Potential Cons
Mutual funds have expenses, typically ranging between 0.50% to 1%, which pay for management and other costs to operate the fund. Some mutual funds have sales charges, or "loads," that investors pay when either buying or selling a mutual fund. Market risk.
Should I redeem my mutual funds now? ›
Any untimely or premature redemption can have an adverse impact on the value of the investment. So if you feel that you are nearing the financial goal that you were saving for and you need money, you should consider redeeming your funds.
How will mutual funds do in 2024? ›
MUTUAL FUND STORY IN MARCH 2024
The month of March 2024 saw the overall mutual fund AUM fall to ₹53.40 Trillion, compared to ₹54.54 Trillion as of the close of February 2024. That was more due to the sharp sell-off in debt funds to support treasury withdrawals.
What is the 8 4 3 rule in mutual funds? ›
The rule of 8-4-3 for mutual funds states that if you invest Rs 30,000 monthly into an SIP with a return of 12% per annum, then your portfolio will add Rs 50 lacs in the first 8 years, Rs 50 lacs in the next 4 years to become Rs 1 cr in total value and adds further Rs 50 lacs in the next 3 yrs to reach Rs 1.5 cr.
Are you supposed to sell mutual funds? ›
If your financial goals have shifted, it may be time to realign by selling. For example, if you initially invested in an aggressive growth fund but now require more stability and income, you might consider selling the fund shares and reallocating your investments.
Does it matter when you sell a mutual fund? ›
You're allowed to sell your mutual fund holdings at any time after buying shares. But there may be consequences based on the type of mutual fund you own. For instance, some fund companies charge an early redemption fee if you sell your shares before a prescribed period of time.
Should I sell my mutual funds when market is high? ›
Interrupting or ceasing investments during market peaks or due to apprehensions about a correction is counterproductive to reaching your financial objectives. Bhatt adds, “Instead of stopping completely, you could choose to reduce your SIP or lump-sum amount until market conditions seem less frothy.
Should I sell mutual funds before recession? ›
Stay The Course With Long-Term Funds
You may ask, Why leave money in mutual funds that lose value in a downturn? The answer is that individual mutual fund shareholders rarely, if ever, get out of the market near its top. And they rarely, if ever, get back into the market at its bottom.
