Do I have to withdraw from mutual funds to pay off debt?

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If you’ve invested money in mutual funds, using them to pay off debt might seem like a good option. You can assume that you will reap more benefits from using the money you invested to eliminate debt (and the high interest rates associated with it). But cashing out your mutual funds may not be the best way to get out of debt if there are other options. And depending on where you hold your mutual funds, you could end up with a high tax bill.

Key points to remember

  • Cashing out mutual funds may not be the best option for paying off debt.
  • You may owe capital gains tax on mutual funds that you withdraw from a taxable brokerage account.
  • Cashing out mutual funds from an IRA or other qualified retirement account could trigger an income tax on income, as well as an early withdrawal tax penalty.
  • Withdrawing money from your investments to pay off debt means missing out on future growth in compound interest.

Pros and Cons of Cashing Out Mutual Funds to Pay Off Debt

Using mutual funds to pay off debt may seem appealing at first glance. If you’re not using the money you put in for a particular financial purpose, then why not use it to pay off credit cards, student loans, or other debt? After all, eliminating debt can free up more money in your budget that you can then reinvest in mutual funds, stocks, or other securities.

However, there are some issues with this logic. Specifically, there are two major drawbacks associated with cashing out mutual funds to pay off debt. The first is the tax; the second is how it can negatively impact your long term financial goals.

In terms of tax implications, there are two ways to cash out mutual funds to pay off debt, depending on where you hold them. If you have mutual funds in a taxable brokerage account, cashing them may trigger a capital gains tax if you sell them for more than what you originally paid for them. Short-term capital gains on securities held for less than one year are subject to the ordinary income tax rate. The long-term capital gains tax rate is 0%, 15% or 20% depending on your income.

If you hold mutual funds in an Individual Retirement Account (IRA), you can avoid capital gains tax. But you can pay ordinary income tax on income, as well as an early withdrawal penalty of 10%, depending on the type of IRA, the length of your account, and your age at the time of withdrawal.

Aside from the tax consequences of using mutual funds to pay off debt, it’s also important to consider the impact it can have on your ability to grow your wealth. By selling mutual funds and not replacing them with other investments, you are missing out on the power of compound interest. Depending on how much of your mutual fund holdings you choose to sell, this could mean a loss of growth of thousands of dollars over time.

advice

If you plan to withdraw mutual funds from a brokerage account, use an online capital gains tax calculator to estimate the amount you might owe on the sale.

Other options for paying off debt

Cashing out mutual funds isn’t the only way to manage debt. There are other possibilities to eliminate debt faster while saving money on interest, including:

If you’re having trouble paying off your debt, you may want to consider other options, such as a debt management plan or debt settlement. With a debt management plan, you work with a certified credit counselor to create a plan for paying back what’s owed. This can include reducing interest rates or fees. You make a one-time payment to the credit counselor, who then distributes the funds among your creditors.

Debt settlement is something you can consider for overdue debts. This involves working with a consumer debt specialist to negotiate debts with creditors. The goal is to pay off debts for less than what is owed to avoid filing for bankruptcy as a last resort.

Important

Managing and settling debt can have potentially negative impacts on your credit score, so it’s important to weigh these options carefully.

Make an informed decision

If you are considering selling mutual funds to pay off debt, it is important to do your research beforehand. Your broker or financial advisor can provide you with the expected rate of return for a mutual fund in the future. Compare this rate to the fund’s historical performance to make sure it is correct. If mutual funds pay dividends, this amount should be included in the valuation. If funds are held in a retirement account, learn about the fees and penalties for withdrawals.

Again, cashing out a Traditional IRA before the age of 59 and a half results in a 10-25% tax penalty. There are exceptions for withdrawals, such as disability, medical debt, certain education expenses, and buying a home. Mutual funds held in regular brokerage accounts have standard commission fees, but the fund itself may still charge a fee for redeeming your shares. Brokers and financial advisers are excellent resources for this information.

The interest rate on your debt and the length of the loan should provide the final evidence to make an informed decision. Debt such as credit cards and short term loans generally have higher interest rates than long term debt such as car loans or mortgages. For mortgages, make sure you have a fixed interest rate. Variable Rate Mortgages (ARMs) can continue to increase over time and result in payments that could exceed your ability to repay them.

To note

A 401 (k) loan is also an option for paying off debt, but if you part with your job before the loan is paid off, the full amount could be treated as a taxable distribution.

The bottom line: is paying debt with mutual funds a good idea?

While getting off debt can be a relief, there are some downsides to consider if you are using mutual funds to achieve this goal. Fees and penalties are red flags when considering cashing out your mutual funds. Losing future investment income and not having a retirement account can put you in a worse position later in life.

You can make additional debt repayments using current income to shorten the loan term and reduce the total amount of interest you owe, assuming your budget allows. If you’re really struggling to pay off your debt, consider reaching out to debt relief companies to see how they can help you.

advice

When looking for debt relief companies, make sure you get a clear explanation of the services they offer and any fees you might have to pay before signing a service contract.


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