How to Deduct IRA Losses

If you're like most IRA owners, you've taken a sizable hit. While it may feel like little consolation, there is a chance you can claim a tax deduction to ease your pain. With traditional IRAs, getting a write-off is possible but not terribly likely. Roth IRA owners, on the other hand, will have a much easier time. Here’s what you need to know.

According to the IRS, you have a tax loss from your traditional IRAs when the following conditions are met:

* You liquidate all the traditional IRAs set up in your name.

* Your total tax basis in the accounts -- which equals the sum of your nondeductible contributions (if any) -- exceeds the liquidation proceeds. Since you only get tax basis from nondeductible contributions, it’s fairly unlikely that you’ll have a tax loss even if you’ve lost your shirt. However, it can happen (as example 1 below illustrates).

Let’s say you do have a tax loss. The IRS says it’s classified as a miscellaneous itemized deduction. As such, it gets thrown into the pot with other miscellaneous deductions -- such as investment expenses and fees for tax advice. Only the excess of total miscellaneous deductions over 2% of adjusted gross income (AGI) can be claimed as a write-off.

Even if you clear that hurdle, you’re still not in the clear. You could lose part of the write-off due to an unfavorable phase-out rule for high-income individuals. Finally, the write-off is completely disallowed for alternative minimum tax (AMT) purposes. So if you’re hit with the AMT, some or all of the hoped-for tax savings will vaporize.

Example 1: You own one traditional IRA that has plummeted in value. Unusually enough, you funded the account with $11,000 in nondeductible contributions, so it has a tax basis of $11,000. When you liquidate the account, you receive just $6,000. At this point, you have a potentially deductible tax loss of $5,000 ($11,000 - $6,000).

The IRS says that $5,000 loss is a miscellaneous deduction subject to the 2%-of-AGI threshold. If your AGI is $100,000, the AGI threshold is $2,000 ($100,000 x .02). Say you have $1,500 in other miscellaneous deductions, for a total of $6,500 ($5,000 + $1,500). You can claim a $4,500 deduction on your Form 1040 ($6,500 - $2,000). However, if you’re a victim of the dreaded AMT, the deduction is disallowed in the AMT calculation. Your actual tax savings may be little or nothing.

Let’s say you aren't getting hit with the AMT. Liquidating the IRA triggers a $4,500 deduction which reduces your taxable income by that amount. If you’re in the 25% federal income tax bracket, the deduction saves you $1,125 (.25 x $4,500). You may reap a state income tax savings too. Plus you’ve got $6,000 in cash.

The downside is you’ve caused a permanent reduction in a tax-favored account balance. Are the current tax savings and cash in hand worth it? That's what you need to decide.

Roth IRAs must be treated separately from traditional IRAs. To have a tax loss from your Roth IRA, the following conditions need to be met (regardless of what’s going on with any of your traditional IRAs):

* You liquidate all the Roth IRAs set up in your name.

* Your total tax basis in the accounts exceeds the liquidation proceeds. With Roth IRAs, all contributions generate tax basis because all contributions are nondeductible. For this reason, you’re much more likely to have a tax loss with a Roth IRA than with traditional IRA.

Unfortunately, all the other hurdles mentioned earlier for traditional IRA losses also apply to Roth IRA losses.

Example 2: You own one ill-fated Roth IRA. It was funded with $20,000 of annual contributions, so it has a $20,000 tax basis. You receive only $9,000 when you liquidate the account. Now you have a potentially deductible loss of $11,000 ($20,000 - $9,000).

As explained earlier, the loss is a miscellaneous deduction subject to the 2%-of-AGI threshold. If your AGI is $100,000, the threshold is $2,000. Say you have $1,500 of other miscellaneous deductions for a total of $12,500 ($11,000 + $1,500). You can claim a $10,500 deduction ($12,500 - $2,000). If you’re an AMT victim, the deduction is disallowed in the AMT calculation.

Again, let’s say you aren't getting hit with the AMT. Liquidating the Roth IRA triggers a $10,500 deduction. If you’re in the 25% federal income tax bracket, you save $2,625 (.25 x $10,500). You may get a state income tax benefit, too. Plus you’ve got the $9,000 in hand. However, you’ve also caused a permanent reduction in the balance of the most taxpayer-friendly type of account known to humankind. Is it worth it? That’s for you to decide

Warning: If you liquidate a Roth IRA that was funded with a conversion contribution (from converting a traditional IRA into a Roth account), you generally must pay a 10% penalty tax if: (1) the liquidation occurs within five years of the contribution (the five-year period is deemed to start on January 1 of the year you made the conversion contribution) and (2) you’re under age 59½. So if you’re 50 years old and funded your Roth IRA with a conversion contribution on June 1, 2005, the five-year period is deemed to start on January 1, 2005. Therefore, you’ll generally owe the 10% penalty if you liquidate the account before January 1, 2010. If you get hit with the penalty tax, it can wipe out some or all of the tax savings from a deductible Roth IRA loss. So be very careful.

The seemingly simple question of whether you can deduct IRA losses really isn’t so simple after all. Please consult your adviser before closing loser accounts in the hopes of gaining some tax savings. All in all, it may be a poor idea unless you desperately need the cash.