I received an email from a reader about whether it was a good idea to sell their non-registered portfolio to pay down debt. As always, my answer was “it depends”. It depends on the interest rate of the debt, how long the term is, the marginal tax rate of the debt holder and the capital gains built into the non-registered account.
As most of you already know, selling stock from a non-registered portfolio may result in a capital gains tax hit along with foregoing future growth. It could also trigger a capital loss which could be applied against capital gains for the year.
Holding high interest debt for the long term, on the other hand, can also be very costly. So which is more efficient? Keep the portfolio along with the debt? Or liquidate the portfolio and pay off the debt?
From what I have read, the general consensus is to not start a non-registered portfolio until all bad debts are paid off. But does that make sense all the time? Here is the readers situation:
- Credit Card Balance: $20,000
- Interest Rate: 18.50%
- Minimum of 3% of Balance/month
- Annualized Non-Registered Portfolio Growth after inflation: 5%
- Portfolio Capital Gains: $5,000
- Marginal Tax Rate: 40%
- Portfolio is invested for capital gains only, no dividends or interest income.
|Required Portfolio Withdrawal After Taxes:||$21,000.00|
|Portfolio Gain after taxes:||$4,641.53||$10,565.43||$18,125.99||$27,775.40|
|Conclusion:||Withdraw||Withdraw||Withdraw||Do Not Withdraw|
Even before doing the calculations, it’s pretty safe to assume that paying off a 18.5% credit card is better than staying invested in the markets. However, what’s interesting is that even at 5% return, it’s better to stay invested if planning to hold the debt for the long term(>15yrs). The reason being is because the investment growth is compounded, where the debt is slowly paid down with the minimum payments.
It’s important to note that the bulk of the interest is accumulated in the first 5 years, so if you have credit card debt in the high teens, it’s obviously in your best interest to pay that off as fast as possible.
For this unique situation, it seems that the “breaking” point for loan interest is around the 8% mark. At this interest rate, it would make more “financial” sense to keep the money in the portfolio assuming that the growth remains at 5% annually. This is shown in the table below.
|After Tax Portfolio Gain:||$4,641.53||$10,565.43||$18,125.99||$27,775.40|
|Conclusion:||Do Not Withdraw||Do Not Withdraw||Do Not Withdraw||Do Not Withdraw|
What stands out in this exercise is that it requires a higher debt interest rate to be equivalent to a lower growth rate portfolio. For those of you who want to do your own calculations, you can download the spreadsheet here.
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