Should You Tax-Loss Harvest in Your IRA?
Conversions and recharacterizations, rather than tax-loss selling, are the better strategy for most.
One silver lining of down markets is the ability to realize tax losses. By selling out of positions that are trading at a price below your cost basis, you can take a loss and use it to offset capital gains. If you don't have any capital gains, you can use the tax loss to offset up to $3,000 in ordinary income.
You often hear about tax-loss selling at year-end, because you have to realize losses by Dec. 31 if you want to use them to lower your tax bill for that year. But there's no reason that investors need to wait until the year's final months to sell a stock, fund, or ETF at a loss. If your holding has dropped in value--or, in the case of late 2015 and early 2016, the whole market has--realizing losses can be valuable no matter what the calendar says.
But what if your biggest losers are in your IRA? If you have losing holdings there, can you find a silver lining, too?
Unfortunately, tax-loss selling inside of an IRA is much more cumbersome, and usually not advisable. Instead, the best way for IRA investors to benefit from a weak market is to consider converting a portion of their traditional IRA to Roth. With prices down, the cost of converting those assets will be less than if the assets were converted when the market was higher.
IRA Tax-Loss Selling: A Lost Cause?
Before getting into the merits of tax-loss selling in tax-sheltered accounts, it's important to understand the tax treatment of tax-sheltered assets in general--IRAs as well as 401(k)s, 403(b)s, and 457 plans.
As long as you keep your money within the confines of these accounts, you won't owe taxes on the income or gains you incur from year to year. You can own a bond that yields 7% or trade rapidly--normally high-tax-cost activities within taxable accounts--but those activities won't have any impact on your year-end tax bill as long as the money stays inside those accounts. Instead, your only tax impact from holding tax-sheltered vehicles will be by having to pay taxes on your initial contributions--as is the case with Roth IRAs, traditional nondeductible IRAs, or Roth 401(k)s--or on your qualified withdrawals--as is the case with traditional IRAs and traditional 401(k)s. Because you're not on the hook for taxes on a year-to-year basis in these accounts, it stands to reason that you wouldn't be able to use losses to improve your tax position in a given year, either.
That said, there may be rare instances in which an investor's cost basis (that is, money that has already been taxed) in a given IRA type is above the current value of all IRAs of that type. That's unlikely to be the case with traditional deductible IRAs, which are apt to consist largely of monies that have never been taxed (deductible contributions, investment earnings, and/or never-been-taxed monies rolled over from the plan of a former employer). Instead, it's more likely to occur with Roth and traditional nondeductible IRAs; within those accounts, a high percentage of the accounts' value may consist of monies that have already been taxed (basis).
IRA Losses Not Usually a Fit
But even if an investor finds herself in that situation, it may not be advisable to sell for a tax loss. Say, for example, an investor's Roth IRAs are currently worth $15,000 and her basis is $30,000. In that case, she would need to sell all of her Roth IRAs to be able to deduct the loss. That requirement stands in contrast with tax-loss selling in a taxable account: Not only can the taxable investor cherry-pick specific accounts to sell for a loss, but she can select specific securities and even specific lots of that security (provided she has elected the specific share identification method for her cost basis) to unload. In short, the taxable investor can take a more surgical approach.
Additionally, having withdrawn all of her Roth IRA assets in an effort to deduct her tax loss, our hypothetical investor couldn't turn around and shovel the $15,000 that she withdrew back into another Roth IRA. Instead, she'd be subject to the annual contribution limits for IRAs--$5,500 for those under 50 and $6,500 for those 50-plus. Thus, if she's under 50, it would take her nearly three years to get the same amount of money back into a Roth IRA, and there's a risk that her income would be too high to qualify for direct Roth IRA contributions in the first place.
Another crucial distinction between tax-loss harvesting in taxable accounts versus an IRA is that those IRA losses are treated differently on your tax return. Whereas taxable IRA assets can help offset capital gains or even up to $3,000 in ordinary income, IRA losses are part of the miscellaneous itemized deductions you claim on Schedule A of your Form 1040. Those miscellaneous itemized deductions must run in excess of 2% of your adjusted gross income to be deductible, and individuals who take the standard deduction can't use them.
Conversions and Recharacterizations: A Shinier Silver Lining
As is probably clear from the above, selling from an IRA to reap a tax benefit is not often feasible, and even when it is, it may not be advisable. The best candidates will tend to be newly arrived Roth IRA investors whose accounts are still small, have values below their basis, and itemize their deductions.
That's not to suggest that other IRA investors can't take advantage of a weak market to improve their tax positions, however. One of the key strategies that IRA investors should consider, especially if they're seeking tax diversification or believe they'll be in a higher tax bracket in retirement than they are today, is to convert a portion of their traditional IRA assets to Roth. The virtue of doing so when their accounts have declined is that they'll owe ordinary income taxes on the amount converted that consists of deductible contributions and investment earnings; it's more advantageous to do conversions when the account values are down than when they're up.
Meanwhile, investors who converted traditional IRA assets to Roth when their account values were higher might consider recharacterizing those assets back to traditional, provided they're still within the deadlines for doing so. (For a conversion done in 2015, for example, an investor would have until Oct. 15, 2016, to recharacterize.) By undoing the conversion and converting the account at a later date, the investor would incur a lower tax bill than on the earlier conversion, completed when the account was worth more.