Most IRA account holders cannot benefit from deducting losses if their IRA loses value. The benefit of IRA accounts is that they are long-term investments providing for tax deferred growth. IRAs are structured so that any tax impact is deferred until money is actually withdrawn from the IRA in a distribution from the account. (Traditional vs Roth IRA: which is right for you?)
It’s almost always better to do your asset re-allocation inside the IRA plans rather than to take distributions and have the money outside of the IRA plans. Traditional IRA account holders who only put in tax deductible contributions can never recognize a loss because tax was never paid on the contributions and therefore, they have no tax basis to deduct.
Traditional IRA account holders who made nondeductible contributions and Roth IRA holders will have basis from the nondeductible contributions made over the years but would only be able to claim a loss when all IRAs of the same type are cashed out. In other words, you’d have to cash out all your traditional IRAs or all your Roth IRAs. Keep in mind you cannot cash out only your nondeductible IRAs, as all traditional IRA accounts would have to be liquidated to obtain the loss deduction.
Losses in Roth IRA accounts work a little better than traditional IRA accounts. If the values of your Roth IRAs have dropped below your total contributions, then the entire value of the accounts can be cashed out and you might be able to take a deduction for the loss without the distribution being subject to the early distribution penalty.
If the IRA account holder’s standard deduction amount is greater than the combined itemized deductions, the account holder will get no benefit from the loss. Even if the combined itemized deductions exceed the annual standard deduction amount in the year of the distribution, the tax benefit is mitigated since those losses are treated as miscellaneous itemized deductions subject to the 2 percent of adjusted gross income limitation reported on Schedule A, rather than a capital loss. Unfortunately miscellaneous itemized deductions can also be adjusted out by the alternative minimum tax, which further erodes the tax benefit of claiming the loss.
If the Roth IRAs have lost value but their combined value is not below the total amount of contributions made into the accounts, then there is no loss for tax reporting purposes. At this point, it makes more sense to hold on to the accounts rather than liquidate the accounts and maintain the tax-deferral on the gains you already have in the Roth IRA accounts.
A traditional IRA can be converted to a Roth by including the amount of the rollover as part of gross income in the year of conversion, less any basis in the traditional IRA due to nondeductible contributions. If an individual converts a traditional IRA to a Roth which quickly loses value, it may be of benefit for the individual to recharacterize the conversion if you are still within the permitted time period and not pay tax on the conversion. You could then reconvert in a subsequent year if the desired investment value recovers.
Be sure to check with your WK advisor before you cash out IRA accounts so you understand the tax consequences. Contact us at (573) 442-6171 or (573) 635-6196 and we’ll be glad to help.