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 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.
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.
FAQs
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.
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.
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.
Is it good time to withdraw money from mutual fund? ›
The right time to redeem mutual funds depends on your financial goals and the performance of the fund. You should redeem your units when you are close to achieving your goal or when the fund is not meeting your expectations.
How much tax will I pay if I cash out my mutual funds? ›
If you receive a distribution from a fund that results from the sale of a security the fund held for only six months, that distribution is taxed at your ordinary-income tax rate. If the fund held the security for several years, however, then those funds are subject to the capital gains tax instead.
Is it the right time to exit from mutual funds? ›
From about 9-12 month prior to your need for the money, is the right time to start withdrawing your investments. However, do not do it in one shot, follow a systematic strategy for this as well, like Systematic Withdrawal Plan (SWP) or Systematic Transfer Plan (STP).
Is there a penalty for cashing out mutual funds? ›
You generally can withdraw money from a mutual fund at any time without penalty. 7 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.
Is it better to keep cash or pay off debt? ›
While paying down high-interest debt will help you reduce the amount of interest you owe, not having an emergency fund can put you deeper in the red when you have to cover an unexpected expense. “Regardless of [your] debt amount, it's critical that you have money set aside for a rainy day,” Griffin said.
Do millionaires pay off debt or invest? ›
Millionaires typically balance both paying off debt and investing, but with a strategic approach. Their decision often depends on the interest rate of the debt versus the expected return on investments.
Should I dump my savings to pay off debt? ›
“Every single day your high-interest debt goes unpaid, it's costing you money — a LOT of money — in interest,” Krawcheck says. Instead of putting your extra cash toward an emergency fund, she suggests that focusing all of it on credit card debt first will save you more in the long run.
Reaching financial goal
If you've achieved your goal a little sooner, you should consider redeeming your investment. If your estimated holding period has ended and you haven't reached your goal, it's time to pull up a SIP calculator to see how many more monthly contributions you'll need to make to achieve your target.
What to do if your mutual funds go down? ›
So, if you notice a loss in your mutual fund portfolio, it is best to keep yourself calm instead of making a big decision. The aim should be a long-term investment plan while dipping into mutual funds investment, as it works well. Also, build a mutual fund portfolio that aligns with your long-term financial plan.
How long should I keep my money in mutual funds? ›
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.
How do I withdraw money from mutual funds to avoid tax? ›
Systematic Withdrawal Plan (SWP): Set up an SWP to automatically redeem your mutual fund units regularly. By keeping withdrawals below Rs. 1 lakh per year, you may avoid LTCG tax altogether.
Can you take money out of a mutual fund without paying taxes? ›
Distributions and your taxes
If you hold shares in a taxable account, you are required to pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares. The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year.
Can I switch mutual funds without paying taxes? ›
If you switch from an equity fund before one year, you will have to pay short-term capital gains tax at 15%. If you switch after one year, you will have to pay long-term capital gains tax at 10% on the gains exceeding Rs. 1 lakh in a financial year.
What is the right time to redeem mutual funds? ›
Cut-off time for mutual fund transactions
| Type of schemes | Cut-off time in IST |
|---|
| Liquid Funds and Overnight Funds (Redemption incl. switch-outs) | 3:00 PM |
| All other schemes (Subscription incl. switch-ins) | 3:00 PM |
| All other schemes (Redemption incl. switch-outs) | 3:00 PM |
1 more rowTimes to Sell
While they are good investment options for several investors, you may think of redeeming the shares in your mutual fund in the following circ*mstances: If the fund manager has changed. If the investment plan and strategy of the fund has been altered. If the fund has been consistently underperforming.
How long should you hold a mutual fund? ›
You should plan to hold your mutual funds for at least 5 years. In the short term stock and bond fund prices can be volatile. Yet, over the long term their prices typically go up. The instruments can deliver more stable returns if you increase the holding duration to 10 years or more.
When should you pull out of a fund? ›
Selling an outperforming fund
Lowco*ck adds that when a fund has been outperforming over a period of six months to three years, it is a good idea to take profits in order to protect capital in case the market turns. "If you don't, the market will do it for you," he added.
