Have Your Cake and Eat It, Too!
December 2005
When it comes to tax planning, weird ideas abound. Have you heard the one about taking losses on tax-deferred accounts? Hey, wait a minute – that’s not such a weird idea – it can be done!
Let’s say you opened an IRA in 1987 with $2,000 and, after more than a decade of investing in a high-risk venture, it’s now worth $300. Many experts will tell you that IRA losses may not be deducted from your taxes, and they are correct with respect to investment losses – these can offset investment gains in your account only.
However, there are several special circumstances under which losses in tax-deferred accounts may be deductible – these are in accounts where you have after-tax contributions (aka “basis”): Roth IRA’s, nondeductible traditional IRA’s and Qualified Tuition Programs, also known as Section 529 plans. Let’s look at each case:
Traditional IRA
If you have a loss in your traditional IRA, you can recognize that loss if you take full distributions of all of your traditional IRA accounts and the total distribution is less than your basis in the account(s). For example, you have 2 traditional IRA’s in which you have made a total of $8,000 in nondeductible contributions over the years. The value of IRA No. 1 is now $1,500, and the value of IRA No. 2 is now $4,000. If you close both IRA accounts, your deductible loss would amount to $2,500, because the total distribution ($5,500) was less than you basis in all of the IRA accounts ($8,000). Also, you would owe no taxes or penalties on this distribution, because it's effectively a return of your original investment.
Roth IRA
Basically, the rules are the same for a Roth IRA. But it's much easier to claim a loss on a Roth IRA because, by definition, contributions or conversions, or both, are nondeductible. For example, say you have $10,000 in basis in the Roth IRA. If your one and only account has a value of $1,500, you would recognize a loss of $8,500.
Section 529 Plan
Like the Roth IRA, all contributions are nondeductible. Thus, you can deduct any un-recovered basis in the account upon receipt of your final distribution.
So, where do you take the loss? You might think that you would be able to claim the loss as a capital loss, but the IRS takes the position that any losses in tax-deferred accounts are deductible as a miscellaneous itemized deduction, subject to the 2% of adjusted gross income (AGI) rule. So in the above Roth IRA example, if AGI is $80,000, you would need a loss in excess of $1,600 to get over the 2% of AGI “hump”. In this example, his loss is greater than the 2% AGI floor, so he would be able to deduct a loss of $6,900. The loss representing the $1,600 “floor” amount is gone forever.
What about 401(k)’s? These plans are comprised of pre-tax dollars, so, no matter how much you lose in your 401(k) you cannot get a tax break
The real lesson here is that maybe a retirement account or college savings plan is not the place to take speculative risks. Such an account is the place to maintain a diversified investment portfolio with minimum exposure to high-risk investments.
Call us at Cover & Rossiter for help with all of your tax planning and investment planning needs.