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You’ve probably heard that the path to financial success involves paying off all your debt, saving at least 10% of your money, cutting spending, building an emergency fund and maximizing your retirement plan contributions. But the reality is that most Americans live on a limited budget, even paycheck-to-paycheck, and it can be hard if not impossible to accomplish all of these financial tasks.
If you have stocks, for example, it can be hard to know if you should stick with your investment plan or liquidate what you own to pay off your debt. Here are some of the factors you should consider so that you make the right moves on your path to financial independence.
The Cost of Your 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. 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%. Since the long-term average return of the stock market is about 10%, it makes mathematical sense to give up potential returns of 10% for the certainty of eliminating a 20% debt. However, there are additional factors to consider in this equation beyond the straight mathematics.
Your Tax Situation
In the financial markets, there are always consequences to taking action. If you sell your stocks, not only are you giving up potential future gains, you’ll also have to consider your tax liability.
If you sell a stock one year or less since you bought it, any gains will be taxed at short-term gain rates, which are the same as your ordinary income tax rate. If you’re a high earner, that might push your rate as high as 37%. You may also owe state capital gains taxes. In that case, the $10,000 in stocks you sell might only translate to $6,300 that you could use to pay off your debt. It’s a good idea to sit with a tax or financial advisor to help you figure out all the tax ramifications of selling your stock.
One option to consider when it comes to your tax situation is to sell off your losing stocks and use them to offset your capital gains. This way, not only will you avoid paying taxes on your sale, you’ll actually be able to avoid taxes on a comparable amount of gains that you have. You can even use $3,000 per year in losses to offset your ordinary income.
Using the proceeds to pay down your debt in this way not only avoids a tax problem but also provides a financial benefit.
Your Long-Term Financial Plan
It can be easy to think of stocks as something of a disposable commodity, especially if you buy and sell them with regularity. But stocks should be seen as the cornerstone of a long-term financial plan.
Thanks to the power of compound interest, a relatively small investment today can turn into a large sum by the time you retire — but it works both ways. If you are thinking about selling some stocks today, try to think of the value you’re giving up in the future instead of simply the present value. For example, selling $5,000 of stocks at age 30 might not seem like that big a deal. But if you think instead of the $163,000 that money would grow to by the time you reach age 65 — assuming a 10% annual return — suddenly the consequences of your decision become a lot larger.
Low-Cost Alternatives
If you can reduce the cost of your outstanding debt to a reasonable level, it might be the best of both worlds. You won’t have to sell your stock to pay off your debt — keeping your long-term financial plan in place — and your low interest rate will prevent your debt from running out of control, making it more manageable in terms of paying it off.
One option is to find a 0% balance transfer offer from a credit card company. Although this won’t reduce the amount of your debt, it will keep the balance frozen in place for 12, 18 or even 20 months, based on current offers. This gives you a leg up in terms of chipping away at the balance. Just remember that most balance transfer offers come with an upfront fee of 3% to 5% of your balance, so you’ll have to factor that into the overall cost of your debt.
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