If you have some money invested in mutual funds, using them to pay off debt may seem like an attractive option. You may assume that you'll get more benefit from using the money you've invested to eliminate debt (and the associated high-interest rates). But cashing in your mutual fund may not be the best way to become debt-free if there are other options available. And depending on where you hold your mutual funds, you could end up on the receiving end of a steep tax bill.

Key Takeaways

  • Cashing out mutual funds may not be the best option for repaying debt.
  • You may owe capital gains tax on mutual funds you cash out from a taxable brokerage account.
  • Cashing out mutual funds from an IRA or another qualified retirement account could trigger income tax on earnings as well as an early withdrawal tax penalty.
  • Withdrawing money from your investments to pay debt means missing out on future growth from compounding 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 aren't using the money you've invested for any particular financial goal, then why not use it to pay off credit cards, student loans or other debts? After all, eliminating debt can free up more money in your budget that you can then re-invest in mutual funds, stocks or other securities.

There are some problems with that logic, however. Specifically, there are two major drawbacks associated with cashing out mutual funds to pay down debt. The first is taxes; the second is how it may negatively impact your long-term financial goals.

In terms of tax implications, there are two ways cashing out mutual funds to pay debt can backfire, depending on where you hold them. If you have mutual funds in a taxable brokerage account, then cashing them out may trigger capital gains tax if you're selling them above what you initially paid for them. Short-term capital gains on securities owned for less than one year are subject to ordinary income tax rates. The long-term capital gains tax rate is 0%, 15% or 20%, depending on your income.

If you hold mutual funds inside an Individual Retirement Account, you can avoid capital gains tax. But you may pay ordinary income tax on earnings as well as a 10% early withdrawal penalty, depending on the type of IRA, how long you've had the account and your age at the time of withdrawal.

Aside from the tax consequences of using mutual funds to pay down debt, it's also important to consider how it may impact your ability to grow wealth. By selling off mutual funds and not replacing them with other investments, you miss out on the power of compounding interest. Depending on how much of your mutual fund holdings you choose to sell, that could mean losing thousands of dollars in growth over time.

Tip

If you're considering cashing out mutual funds in a brokerage account, use an online capital gains tax calculator to estimate how much you may 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 for eliminating debt faster, while also saving money on interest including:

  • Refinancing student loans, personal loans or other loans at a lower interest rate
  • Consolidating credit card debts into a single personal loan
  • Taking advantage of 0% credit card balance transfer offers
  • Using a home equity loan to consolidate debts
  • Selling vehicles or other non-investment assets you own and applying the proceeds to your debt balances

If you're struggling with debt repayment, you may 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 off what's owed. This may include reducing interest rates or fees. You make a single payment to the credit counselor who then distributes the funds among your creditors.

Debt settlement is something you may consider for past due debts. This involves working with a consumer debt specialist to negotiate debts or negotiating debts with creditors directly. The goal is to pay off debts for less than what's owed in order to avoid filing bankruptcy as a last resort.

Important

Debt management and debt settlement may have potentially negative impacts to your credit score so it's important to weigh these options carefully.

Making an Informed Decision

If you're considering selling mutual funds to pay off debt, it's important to do your research beforehand. Your brokers or financial advisor can provide you with the expected rate of return for a mutual fund going forward. Compare this rate to the fund's historical performance to ensure its accuracy. If the mutual funds pay dividends, this amount should be included in the assessment. If funds are held within a retirement account, find out the fees and penalties for cashing out.

Again, cashing out of a traditional IRA before age 59.5 results in a 10 to 25% penalty tax penalty. There are exceptions for withdrawals such as disability, medical debt, certain educational expenses, and buying a home. Mutual funds held within regular brokerage accounts have the standard commission charges, but the fund itself may still charge a fee fo redeeming your shares. Brokers and financial advisors are great resources for this information.

The interest rate on your debt and the length of the loan should provide the last pieces of evidence to make an informed decision. Debts such as credit cards and short-term loans typically have higher interest rates than longer-term debts such as vehicle loans or mortgages. For mortgages, check to make sure you have a fixed interest rate. Adjustable-rate mortgages (ARMs) can keep increasing over time and lead to payments that might balloon over your ability to repay them.

Note

A 401(k) loan is also an option for repaying debt but if you separate from your job before the loan is repaid, the entire amount could be treated as a taxable distribution.

The Bottom Line: Is Paying Debt With Mutual Funds a Good Idea?

While becoming debt-free may be relief, there are some downsides to consider if you're using mutual funds to achieve that goal. Fees and penalties are red flags when thinking about cashing in your mutual funds. Loss of future investment income and the lack of a retirement account can put you in a worse situation later in life.

You can make additional debt payments using current income to shorten the length of the loan and reduce the total amount of interest you have to pay, assuming your budget allows it. If you're truly struggling with how to repay debt, consider reaching out to debt relief companies to see how they may be able to help.

Tip

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