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TAX-LOSS HARVESTING is a popular strategy at this time of year. It works best with mutual funds and exchange-traded index funds, for which very similar investments exist. By swapping your losing funds for similar investments, you can realize your tax losses and maintain your market exposure without violating the wash-sale rule.
By contrast, tax-loss harvesting is difficult to implement with individual stocks. Is there a “nearly identical” investment for a company such as Tesla or Amazon? Furthermore, tax-loss harvesting only applies to taxable accounts, not tax-sheltered ones, which is where Americans hold the bulk of their retirement savings.
Still, there’s a long-term strategy that investors can employ to capitalize on losing investments—including individual stocks—that’s tailor-made for tax-deferred accounts. The strategy: Perform a Roth conversion of the temporarily (we hope) down and out investment.
To see how this works, imagine you invested $20,000 in Alibaba stock (symbol: BABA) within your IRA at the beginning of 2021. After this year’s beating, your holding is now worth just $10,000. If you still believe in the stock and plan to hold it long term, a Roth conversion of your Alibaba stock could make a lot of sense.
If your marginal tax bracket is, say, 22%, you would owe $2,200 in taxes (22% of $10,000) on the Roth conversion. But once the stock is in your Roth IRA, you’ll never owe taxes on it again. If the stock soars in value over the next decade—the best-case scenario—you just saved yourself a bundle in future taxes.
I believe this strategy is underutilized for behavioral reasons. First, there’s inertia. It takes work to file the necessary paperwork to do the Roth conversion. Second, humans are strongly present-biased. The tax savings from this strategy, however generous, won’t be enjoyed for years or even decades. But the pain of paying taxes on the conversion today is front and center in our minds. Finally, it’s painful to attend to our losing investments. Our pride is at stake.
Behavioral quirks aside, there’s a little discussed downside to holding investments inside a Roth account. If the investment does poorly—say Alibaba is nationalized and your stock becomes worthless—you absorb the entire loss. Not so for investments held in a traditional IRA or 401(k). In these accounts, you and the Treasury are effectively investment partners, since the federal government has a partial tax claim on every dollar inside a traditional retirement account. If your account balance falls, so too does your tax liability.
Individual stocks can and do occasionally go to zero. A broadly diversified index fund, on the other hand, will never suffer that fate. Hence, it’s probably safer to use this strategy for diversified investments such as mutual funds, particularly index funds. For instance, given the drubbing that emerging market stocks have undergone this year, emerging markets funds may now be great candidates for this strategy.
Nice article, John. It highlights the types of year-end analysis we should be doing to try and optimize our personal situation. For those of using retirement, it might be accelerating an IRA withdrawal if we happen to be in a low taxable income year (or have unusually high deductions that year).
I used this strategy in late 2012 to convert my Microsoft stock from my traditional IRA to my Roth IRA. I had purchased Microsoft in 2007 and 2008 at an average cost basis of $29.80 per share, but it was down to $26.67 when I did the conversion. I had a few other stocks to consider, but fortunately concluded that Microsoft was the least likely among them to go to $0. While it was indeed a good move (and my first and only attempt), I agree with John that the risk is just too great to use individual stocks, and the strategy is best deployed using index funds.
Interesting article John. It’s another good reminder of one of the many benefits of diversification. A well-diversified portfolio, by definition, has some assets that are doing well, and some that are doing not as well–nearly always at the same time. If you are a fan of Roth conversions, and especially if you like to spread your conversions out over the whole year, you can attempt to use this to your advantage. You do this usually by converting the asset class that’s having a down period at the moment, especially early in the year. Then, if you want to do more conversions later in the year, but all of your stock funds are doing well, you just limit your conversions to your slower-growing bond assets, and/or stock funds that haven’t had quite as good a year. Of course, there’s plenty of variations of this, enough to keep a math geek like myself very happy:)
Bonus question: What happens if you own one or two stocks exclusively in a traditional IRA, convert them to a Roth, and then those stocks in the account become worthless by the end of the year? Are you still on the hook for paying the income tax to convert the account?
Once the holding leaves the IRA a taxable event has occurred, what happens to it once it’s in the Roth means nothing from a tax perspective.