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.