Having just survived another tax season, many tax filers will be on the hunt for any write-off or deduction that may help reduce their future tax liability. In the spirit of making lemonade out of lemons, many have used losses on capital assets to ease the tax burden. In that regard, I’m often asked if there’s any benefit to losses in IRA accounts. As the case seems to be with any tax related questions, the answer is a definitive – Maybe.
Almost everything you own and use for personal or investment purposes is a capital asset, but you may deduct capital losses only on investment property, not on property held for personal use. And the fact you lost money on investment property doesn’t automatically qualify it as a deductible loss. For example, for a loss to be deductible, you must have established basis in the investment, which may only be created with money that has already been taxed.
This may present an issue with Traditional IRAs as contributions are typically made on a pre-tax basis. You may, however, be able to deduct a loss in a Traditional IRA if you’ve made any after-tax, non-deductible contributions, which establishes basis in your IRA.
If you have made non-deductible contributions to your Traditional IRA, it’s important to understand you don’t necessarily have a deductible loss simply because one or more investments you hold in the IRA lost value. Rather, the ability to deduct a loss is determined by whether or not the total value of all of your Traditional IRAs is less than the total basis across all of your Traditional IRAs.
For example, let’s say you opened and funded a Traditional IRA with a $5,500 non-deductible contribution. If the value of the Traditional IRA drops below $5,500, you may have a deductible loss. Now, let’s assume you already owned a separate Traditional IRA worth $20,000, funded entirely of pre-tax contributions. In this case, you would only have a deductible loss if the total value of both IRAs fell below your basis, which in this example, is $5,500.
Roth IRAs are always funded with after-tax money, whether from regular contributions or conversions from Traditional IRAs. In order for you to have a deductible loss in a Roth IRA, the total value of all your Roth IRAs must be less than the total value of all contributions and conversion amounts made across all of your Roth IRAs.
To realize an IRA loss, you must distribute every dollar and close out the IRA. Furthermore, when dealing with Traditional IRAs, you must withdraw every dollar from all of your Traditional IRAs, including any SEP IRAs and SIMPLE IRAs, you may own.
Similarly, if it’s a ROTH IRA, you must close out every ROTH IRA you own. Be careful when liquidating and taking a loss on a Roth IRA account. If you are younger than 59 ½, a 10 percent penalty will apply to any conversion amounts not held for 5 years.
Claiming a loss in an IRA is different from claiming a loss on an investment held outside an IRA. When dealing with non-IRA investments, capital losses are first used to offset any capital gains you may have realized. If your capital losses exceed your capital gains, you may deduct the capital loss on your tax return and reduce other income, such as wages, up to an annual limit of $3,000. Any net capital loss in excess of $3,000 may be carried over to the following years until used entirely.
On the other hand, a loss from an IRA is claimed as a miscellaneous deduction on Schedule A. Not only does this require you to itemize deductions, but since miscellaneous deductions are subject to 2 percent of your Adjusted Gross Income (AGI), you only benefit from losses exceeding that threshold. For example, assuming your AGI is $50,000, you won’t realize any benefit on the first $1,000 of miscellaneous deductions ($50,000 x .02). If you realized an IRA loss of $3,000, you’ll be allowed to deduct $2,000 ($3,000 minus the $1,000 floor).
Furthermore, if you’re subject to the Alternative Minimum Tax (AMT), you won’t benefit from an IRA loss as miscellaneous deductions are lost under the AMT calculation.
The idea of taking a loss on any IRA may sound intriguing, but the consequences may outweigh any potential benefit. For example, once you have liquidated all of your IRAs, the only way for you to get money back into an IRA is through regular annual contributions, or in the case of Roth IRAs, regular contributions and conversions.
In either case, you may lose out on decades of tax-deferred and tax-free growth.