Deducting your IRA losses
Question: I have a loss on stocks in my IRA account. Can I sell those stocks and then use the loss to offset gains outside my IRA? —Michael L., The Woodlands, Texas
Answer: Earlier this week, I wrote a column explaining how investors may be able to capitalize at least a little bit on the current market slump by harvesting investment losses in taxable accounts and trimming their tax bill in the process.
But given the battering retirement accounts have taken lately – the Boston College Center for Retirement Research estimates that the value of stocks held in IRAs and 401(k)s has declined by $2 trillion for the 12 months through October 9th – I’m sure there are plenty of people wondering whether they might be able to deduct losses in such accounts.
Alas, the short answer is probably no. It’s a lot harder to take a tax loss in IRAs and the like than it is in a taxable account.
That said, there are limited circumstances under which you might be able to take a deductible loss in a tax-advantaged retirement account. Even if you can, however, it’s questionable whether it’s a good idea.
Let me start by explaining why it’s unlikely you would be able to turn losses on investments held in IRAs, 401(k)s and the like to your tax advantage in the first place.
Establish a basis
Let’s say you contributed $5,000 to a traditional deductible IRA at the beginning of this year and bought 500 shares of a stock trading at $10 a share. And let’s assume the price of that stock has since sunk to $5 a share, leaving you with a $2,500 loss.
You might figure that you should be able to apply that loss against gains outside your IRA or otherwise deduct it, as you could with a loss in a taxable account.
But tax rules don’t allow for a tax break in this case, which makes perfect sense when you think about it.
After all, when you made the contribution to your IRA, you got a tax deduction that reduced your tax bill. If you also get to deduct a loss on an investment made with that money, you would be getting two tax breaks on the same dollars. Uncle Sam is generous with retirement accounts, but not that generous.
Which brings us to the heart of the matter about losses in retirement accounts: To have a shot at deducting them, you must have money in your account on which taxes have already been paid. That gives you what is referred to in tax circles as “basis,” which is essentially the value of after-tax dollars you have tied up in an investment.
In the case of a traditional IRA and 401(k), you would have basis only if you made nondeductible or after-tax contributions. All your contributions to Roth accounts, on the other hand, qualify as basis since you can contribute only after-tax dollars to Roth accounts.
Cash in
But even if you have basis in an IRA, you can book a tax loss only if you cash in your IRA and its liquidation value is less than the amount of after-tax contributions in your account. You can’t take the loss without closing the IRA.
In fact, the rules are more stringent than that. If you own more than one traditional IRA, you would have to liquidate all your traditional IRAs to establish a loss. The same goes for Roth IRAs. If you wanted to book a loss on your Roth IRA, you would have to liquidate all Roth IRAs, if you have more than one. You can’t cherry pick only IRA accounts where you have a loss.
The rules for losses in 401(k) accounts aren’t spelled out as definitively, but the consensus of the tax gurus I talked to about the issue is that the same principles apply to 401(k)s, with one difference: if you have several 401(k)s, you wouldn’t have to liquidate them all to take a loss in one of them. (Of course, if you have a loss in a 401(k) with your current employer and you’re not switching jobs or retiring, cashing out isn’t an option anyway.)
Establish a loss
But let’s be real here. It’s unlikely many people would be able to establish a loss for tax purposes in a traditional IRA or a 401(k). That’s because balances in these accounts usually consist of dollars that have yet to be taxed – deductible or pre-tax contributions and untaxed investment earnings.
Even if you have after-tax dollars in such an account that would give you the tax basis you need to establish a loss, the loss would have to be so large that it wipes out all your deductible or pre-tax contributions as well as all the earnings in the account. Only after that would you be in tax-loss territory. That’s a big hurdle, especially if it’s an account you’ve been contributing to for several years.
The bar is lower for Roth accounts. Since you’re contributing after-tax dollars, only the earnings in a Roth account stand between you and a tax loss. Given the magnitude of recent stock losses, it’s quite possible that anyone who opened a Roth over the past year or so could be sitting on a deductible loss.
Itemize deductions
But even if you have a loss in a tax-advantaged retirement account, turning it into a worthwhile tax benefit is another matter.
When you have a capital loss in a taxable account, you simply use it to erase a realized capital gain you have from another investment or, in some cases, apply at least some of the loss against wages or other income.
But losses in IRAs and similar accounts must be taken as a miscellaneous itemized deduction. That means you can take the deduction only if you itemize, as opposed to taking the standard deduction when you file your taxes. You can deduct only the portion of your miscellaneous deductions that exceeds 2% of your adjusted gross income. Even then, you could lose some or all of the benefit of the deduction if you end up being subject to the dreaded AMT, or alternative minimum tax.
Weigh your options
Finally, I doubt that it would make sense to take the loss in a tax-advantaged account even if you did manage to qualify for it.
Why? Well, you may get a tax break with the deduction, but by cashing out your account you’ll also be giving up tax-deferred growth on your money, or tax-free growth in the case of a Roth.
If you really want to recoup your losses and even increase the value of your account, your chances of doing that are better by keeping your money in a tax-advantaged account where it can grow without the drag of taxes.
Bottom line: If it’s investment tax losses you’re after, you’re probably better off turning your attention to securities you own in taxable accounts.
But if you’re looking to safeguard your retirement in today’s tumultuous market, I think your time would be better spent reviewing your overall retirement-planning strategy.
J, I was thinking the same thing, only my Roth is a few years old and this year's losses wiped out not only several year's worth of gains, but also a bunch of my contributions. Really makes you want to invest… Anyway, I don't think that money taken out of a Roth offsets the year's contributions into the Roth. So if you put in $5000 this year (the limit for 2008), then close the account and take a loss, you can't put the $5000 into a new Roth until next year (anytime after Jan 1). This would be fine, if you plan to make no other contributions in 2009. So in this one case, I think you could get some tax relief. But, you'd have to wait until Jan 1, 2010 to make more contributions to your Roth, and you may miss out on all the prime buying early in 2009.
Wow Jay. A CFP and ChFC and you contend that there is no way to deduct losses in an IRA? Read the fine print. I believe Mr Updegrave hit the nail all over the head and then some. Point is, reality sets in and most wouldn't see any significant tax savings due to the rules. If you still don't believe it, sit for the CPA exam and study tax law for the next 20 years or so. Maybe then you will discover that the article is correct. (Not irresponsible journalism.)
Lonnie Harris, CPA
However, now could be the time to convert some traditional IRA money to ROTH instead. Your holdings are worth less,you pay the taxes, and then in the roth they can grow tax free.
Dave,
It is all related to the fact that your money in an IRA is in a tax deductible vehicle. Say you put 5K in your IRA and received a $1500 tax benefit. Now if you have IRA losses by deducting them you would be getting an additional tax benefit. Basically double dipping then.
If it outside a tax deductible vehicle then there is no issue because the government never gave you anything.
The one thing I really hope out of all this is people become all the more vigilant in the risk involved in investing. Everyone complains after the fact, but going in you have to know these types of things can happen. If you want little or no risk but T-bills.
ok, one more wrench. i have 2 ira's. one is a roth one is non-deductible traditional where the value is much less than the basis. what happens when i roll the traditional into the roth in 2010. I beleive I can deduct the loss to the extent it exceeds 2% of my adjusted gross income. That sound right.
You cannot take a loss in an IRA account. If you have a Roth IRA, you can cash out your contributions at any time with penalty just not any earnings. If you have no earnings, you could take out the entire amount. Still, as you contribution is not deductible, pulling your money of out the account to take a lose is ridiculous.
If you have a regular IRA, just sit tight. Cashing it out to "take a loss" not only locks in the loss itself but subjects you to unnecessary taxes if you are under 59 1/2. Best thing it do with a traditional to take a loss, it to convert the new lower amount to a Roth. If possible, do shares-in-kind as the value of the position is devalued allowing a lower conversion or taxable amount and keeping the shares if you believe the economy will recover.
If all traditional IRAs would have to be cashed out, could you convert them to Roth IRAs and gain the tax write-off?
What is truely amazing with questions like this is people have just seemed to have forgotten the risk of investing. I have any IRA, real estate, 401K and it upsetting if some or all tanks….but you know what that was a risk I was taking. Everyone wants the reward but no risk. If thats the case stick you money in CDs and accept gains that likely only match inflation.
By the way completely agree with Jay Branson below.
There is another way to benefit from the loss if you have a traditional IRA with tax-deferred funds.
Dont liquidate, but convert your battered stocks to a Roth account, pay taxes now, and all the gains to come are tax-free.
Depending on your marginal rate, a tax accountant can tell if this is a good idea for you.
I think it is funny that all of these people are requesting tax advice from perfect strangers. I agree with ////jay Branson
We sold our house at a loss (like many) and also took out a loan to cover that loss. Are there any tax write offs that we can claim?
I bought a couple of shares of Washington Mutual about a year ago in a Roth IRA. The FDIC stepped in and turned what was supposed to be a long term holding into a definate loss. I think they would have been ok if the FDIC did not step in or at least the WAMU shareholders may have actually recieved something from Chase. The government is obivously good buddies with JPMorgan Chase because they give every finanicial company to them if possible. It is too bad I cannot take a deduction.
Can you explain to me how this idea: "After all, when you made the contribution to your IRA, you got a tax deduction that reduced your tax bill. If you also get to deduct a loss on an investment made with that money, you would be getting two tax breaks on the same dollars. Uncle Sam is generous with retirement accounts, but not that generous." is not the inverse of taxing Capital Gains. IE. you paid taxes on your income and then you're taxed again when your investments make money.
This is a great analysis. He is absolutely right that it is virtually impossible to find a situation with a qualified plan where you could write off a loss, and even if you could, almost certainly would not be to your benefit. With nonqualified plans, it is a great time to sell a Stock Mutual Fund that has a loss and move directly to another stock mutual fund, giving you the Capital Loss, and establishing a new cost basis. This is not a good time to sell unless you are reinvesting directly into the stock market.
Ok, at the beginning of 2008 I made a single contribution of $6,000 (I'm 51) to a nondeductible IRA. It's the only contribution ever made to this account, and I have no other nondeductible or traditional IRAs (although I do have a rollover IRA that has only 401k rollovers, no direct contributions in it). Question: Can I close the $6,000 nondeductible IRA (thereby taking a loss of around $2,000)? If I do, can I then open a new nondeductible IRA for 2008 at a different financial institution and contribute $6,000 to it? I'm not looking to make money, or even to deduct the loss necessarily (although I will if I can). I'm just looking to end the year with $6,000 in a non-deductible IRA instead of the $4,000 that's in it now – even if that means I put up another $2,000 to reestablish my $6,000 contribution for the year.
The answer is a simple No you cannot deduct losses in an IRA. Any other repsonse is simply irresponsible journalism from someone who should know better.
Jay Branson CFP, ChFC
I have a Roth, created this year, with losses. What prevents me from closing the account this year, taking the loss, and reopening next year (one day later). It simply lowers my contribution limit, correct? But can't I count it as the previous year's contribution before April 15th anyways? Net contribution is the same, but take a tax loss by closing and opening the account.
I hopped on the Roth IRA train with a full $4000 contribution at the end of 2007. Unfortunately I just dropped it in an S&P 500 fund, and it has lost 45%.
I just called the IRS and confirmed that I can take the deduction (getting back a quarter of the loss at $400 isn't bad) but I won't be able to contribute again until 2009.
I'm pretty confident that I can eventually earn that $400 back, especially if I put in the $5000 for 2008, whereas I lose a year of tax free growth by waiting until 2009.