Juice from Lemons

John Lim

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.

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