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% in 2024.
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 monthly 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.
What's Another Way To Reduce Debt Besides Withdrawing from a Mutual Fund?
Building and maintaining a good credit history can help you obtain lower interest rates when borrowing, making it easier to save and work toward your financial goals. This can be done in several ways, including consolidating high-interest debt or paying off all credit card balances each month.
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
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.
Should I pull out of my investments 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.
How much tax will I pay if I cash out my mutual funds? ›
Taxes on Mutual Fund Long-Term Capital Gains – Tax Year 2021 (filed in 2022)
| Status of Filer | Single | Married, Filing Separately |
|---|
| 0% | $0 to $40,400 | $0 to $40,400 |
| 15% | $40,401 to $445,850 | $40,401 to $250,800 |
| 20% | $445,851 and higher | $250,801 and higher |
Mar 14, 2022
Typically, the rule of thumb is to remain invested for four to five years for better equity fund returns and two to three years for debt funds. For long-term mutual fund investments, it is advisable to refrain from unnecessary withdrawals to allow your funds to grow steadily.
Should I sell mutual funds to pay off debt? ›
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.
Is there a penalty for withdrawing from a mutual fund? ›
Withdrawing mutual fund investments before the maturity date can attract penalties such as exit loads. Exit loads are fees charged by mutual fund companies to discourage premature withdrawals. Additionally, early redemption may result in higher short-term capital gains taxes compared to long-term capital gains taxes.
Should I exit from mutual funds now? ›
Market Volatility and Risk Management
If a fund consistently underperforms over multiple periods and fails to deliver satisfactory returns, consider exiting the investment. Research and select funds with a similar investment objective but better track records and performance history to redirect your investments.
Are mutual funds safe in a market crash? ›
While market crashes inevitably impact mutual funds' performance and pull them down, as an investor, you need to remain patient and avoid exiting your investment. If you redeem your investment during a market crash, you essentially convert your notional losses into actual ones.
What is the 30 day rule for mutual funds? ›
The 30-day rule refers to a regulation that applies to mutual fund purchases and sales. Under this rule, mutual fund investors who sell shares of a mutual fund and then purchase shares of the same or a substantially similar mutual fund within 30 days are not allowed to claim a loss on their tax return.
If you are interested in a mutual fund that generates capital gains distributions, consider holding the fund in a tax-advantaged account such as an IRA or 401(k), rather than a taxable account. Seek out tax-managed mutual funds.
Should I sell assets to pay off debt? ›
The Cost of Your Debt
It's not costing you anything extra in interest — although it might affect your credit score — and selling off stocks can cost you future growth. However, the situation might be reversed if you have outstanding credit card debt, which can carry interest rates north of 20%.
How to withdraw a mutual fund without tax? ›
By keeping withdrawals below Rs. 1 lakh per year, you may avoid LTCG tax altogether. Selling at the right time: For gains: Consider selling some units before your total LTCG for the year reaches Rs. 1 lakh. This requires monitoring your portfolio and market conditions.
How long should you keep money in a mutual fund? ›
The rule of thumb is five years. If it's a riskier type of fund, such as a small-cap one, then I would say, seven years. But a better approach would be to link your equity fund to a long-term goal, such as your retirement and children's higher education.
Should you stay in mutual funds? ›
Mutual fund investments when used right can lead to good returns, keeping risk at a minimum, especially when compared with individual stocks or bonds. These are especially great for people who are not experts in stock market dynamics as these are run by experienced fund managers.
Should I redeem my mutual funds? ›
Redeeming your funds just because of temporary market flux is uncalled. This is especially true if you are a long-term investor since the markets eventually stabilize. However, you might consider redeeming your funds if your fund underperforms consistently.
Should I use my stocks to pay off debt? ›
A general rule of thumb to consider is that if your expected rate of return on investments is lower than the interest rate on your debt, you should pay down debt first. Historically, the stock market has returned an average of between 9% and 10% annually.
Should I pull my money out of investments? ›
Once you cash out a stock that's dropped in price, you move from a paper loss to an actual loss. Cash doesn't grow in value; in fact, inflation erodes its purchasing power over time. Cashing out after the market tanks means that you bought high and are selling low—the world's worst investment strategy.
Is it better to pay off debt then invest? ›
If the interest rate on your debt is 6% or greater, you should generally pay down debt before investing additional dollars toward retirement. This guideline assumes that you've already put away some emergency savings, you've fully captured any employer match, and you've paid off any credit card debt.
Should you use your equity to pay off debt? ›
Using a home equity loan for debt consolidation will generally lower your monthly payments since you'll likely have a lower interest rate and a longer loan term. If you have a tight monthly budget, the money you save each month could be exactly what you need to get out of debt.
