Tax-loss harvesting works best when your gains and losses are offset – which makes IRA accounts unsuitable for this strategy.
Traditional nondeductible and Roth IRA account holders only recognize a loss upon cashing out their investments, delaying any tax efficiency benefits of the strategy. This can be costly.
It’s Not a Good Strategy
There are several reasons why harvesting losses in an IRA rarely makes sense, chief among them being tax efficiency benefits provided by offseting gains with losses; due to investments growing tax-free within these accounts, however, not many taxable gains arise in return.
Losses from an Individual Retirement Account (IRA) can only be used to offset other sources of taxable income, such as capital gains or up to $3,000 of ordinary income each year. Unfortunately, most people use their IRA solely as retirement savings vehicles rather than offset other sources of taxable income with losses from an IRA.
One other consideration in favor of forgoing IRA tax loss harvesting is the fact that taking withdrawals before age 59 1/2 requires you to pay both income tax and an early withdrawal penalty of 10 percent – unlike when withdrawing funds from a taxable account where only ordinary income tax applies.
It’s Not Easy
Individual retirement accounts, or IRAs, are tax-advantaged investment vehicles designed to encourage people to save for their own futures. They come in three varieties – traditional IRAs, Roth IRAs and rollover IRAs that store money from employer plans like 401(k)s or 403(b).
Investors use IRA money to invest in various assets, including stocks, mutual funds and exchange-traded funds. Each time you buy or sell securities, a “tax lot” is generated; TDAIM then assesses whether these lots have lost enough value to warrant harvesting for tax losses.
Harvesting losses in an IRA has both short- and long-term benefits, depending on how it’s spent. Harvested losses could help rebalance your portfolio if its asset allocation has become imbalanced; invest in stocks on your watch list; or add to an existing position that still has great potential.
It’s Not Tax-Advantaged
IRAs offer tax advantages when saving and investing for retirement. You typically postpone paying taxes until withdrawing funds at retirement or for certain exceptions such as buying your first home or paying higher education expenses.
Due to their tax-avoidance features, IRAs don’t benefit as much from tax loss harvesting than taxable investments do, making taxable accounts the optimal place for investors in higher tax brackets to conduct loss harvesting activities.
That doesn’t mean IRAs aren’t good investments; rather, you should carefully evaluate them based on your tax situation and overall investment strategy. Consider investing through payroll deductions, automatic bank withdrawals or direct deposits so you’re investing consistently month after month.
It’s Not for Everyone
IRAs can be an excellent way to save for retirement. But not all IRAs are created equal – so it’s crucial that you understand the distinctions among traditional, Roth, SEP and SIMPLE IRAs so as to choose an account best suited for you and your needs, goals and financial situation.
Investors in higher tax brackets stand to reap the greatest advantages from harvesting losses in an IRA, which can offset up to $3,000 of their ordinary income (such as interest, wages, dividends or net business income) each year.
But, to comply with the wash sale rule and avoid tax penalties, it’s essential that you don’t buy back investments that you recently sold in an IRA if they violated it. Furthermore, if your tax bracket or retirement age are low it may not make financial sense to sell investments at a loss just to save on taxes; so it is vital that you create an in-depth financial plan and investment strategy which includes both IRAs and 401(k)s as part of a comprehensive portfolio management approach.