Should You Tax-Loss Harvest in Your IRA?

Note: This article is part of Morningstar's Nov. 2016 Year-End Tax-Planning Guide special report. A version of this article appeared Feb. 7, 2016.

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 that strategy is typically best employed by investors who have significant assets within taxable accounts. For investors with the bulk of their assets within tax-sheltered investments (and that's most of us) tax-loss selling will tend to be much less appropriate. Instead, the best way for IRA investors to improve their tax positions will be to consider converting a portion of their traditional IRAs to Roth. But even that strategy will be tend to be much less beneficial when the market is up, as it has been recently.

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. (That's unlikely given the length and breadth of the market's current rally, but bear with me.) 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: 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 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. By converting and paying the taxes at today's tax rate versus a future, higher tax rate, the investor can take tax-free withdrawals in retirement.

Yet such a strategy is arguably best undertaken when either the market is down or the investor finds herself in a particularly low tax year--for example, after retiring but before required minimum distributions have commenced. As the market has scaled new highs thus far in 2016, most investors are likely dealing with high balances, not low ones, though their individual circumstances may still make conversions (or partial conversions) appropriate. As always, seek guidance from a tax advisor or a tax-savvy financial advisor before undertaking any IRA conversions.