When it’s time to make a big purchase, you may be tempted to take money out of your investment accounts. While it may be tempting or sometimes necessary, it is not always advisable to do so.
Financial advisors generally say that selling investments should be avoided if possible, as this not only means that your money will stop growing, but also that you may owe taxes. Remember that your investments are important for long-term financial goals.
But there may be instances when you should consider tapping into your retirement accounts. Here’s how to determine whether or not you should sell your investments to make a big purchase, and what to do if you decide to do so.
Do you need to take money out of your investment accounts for a large purchase?
When you invest in the financial markets, you benefit from compound interest, or the interest you earn on your main investment and interest. Thanks to compound interest and the power of financial assets like stocks, a $5,000 investment, assuming a 7% return, could grow to almost $40,000 in 30 years.
“The more money you put into the investment account – the sooner – the more it will compound,” says Eric Roberge, a certified financial planner and founder of financial planning firm Beyond Your Hammock. The danger of moving your money to the sidelines of the stock market is that it will miss out on compound interest.
But another disadvantage comes from the tax implications. When you sell investments, the IRS requires you to pay taxes on any earnings. Tax-advantaged accounts, such as 401(k)s and IRAs, allow you to minimize your tax burden by letting your money grow tax-free or tax-deferred, depending on the type of account. But you must leave your money in the account until you withdraw it at age 59.5 or later to avoid paying penalties. Taxable investment accounts offer no tax benefits (although you won’t face early withdrawal penalties, either).
Because of these disadvantages, it’s best not to take money out of your investments if you can avoid it, especially if that money is being set aside for retirement.
“Normally you should avoid this if possible,” says Roberge. “Plan in advance and save your money through your income.”
What to do if you need to withdraw money for a large purchase
Sometimes you have no choice but to withdraw money from your investment accounts. If so, there are steps you can take to minimize the impact.
Because you will have to pay capital gains tax on the income when you sell, you should first look at the unrealized gain or loss of the investment to get an idea of how much tax you will owe.
Profits from investments that you have held for at least a year (long-term capital gains) are taxed at a rate of 0%, 15% or 20%, depending on your income. But those you sell less than a year after purchase (short-term capital gains) are taxed as ordinary income, which could be as high as 37% for the 2023 and 2024 tax years.
“It’s much more strategic to sell things that will make a profit in the long term than things that will make a profit in the short term,” says Roberge.
It may also make sense to sell an investment at a loss and offset the taxes on your gains through tax-loss harvesting, he adds. However, it is best to speak with a financial advisor or tax professional first as this can be a complicated strategy.
In short
Selling an investment means missing out on the power of compound interest and the potential growth of that money, plus a possible tax bill. But if you have to sell, do it strategically. Calculate and plan the taxes you will have to pay on the income from that investment, and consider speaking to a financial advisor.
