How and When Can You Deduct a Loss on Your IRA Investments
by Shane Flait (2011)

 

A lot of people have suffered sizeable investment losses in their individual retirement accounts (IRAs). They wonder if they can deduct these losses. Well they can. But they better be desperate for the money. Here’s how it works.

 

The basis and basics of taxable gains and deductible losses

A taxable capital gain and a deductible capital loss comes from selling an investment for more (a gain) or less ( a loss) than you paid for it. The key words are ‘selling’ and ‘paid’. The amount you paid for your investment is called its ‘basis’. Until you sell, your gain or loss – i.e. the difference between the current value of your investment and its basis – is neither taxable nor deductible, whichever the case is.

 

IRAs are qualified retirement plans. They’re meant for long term savings to be withdrawn in your retirement years. Generally your IRA is taxed simply under income tax rules – not capital gains (or loss) tax rules. Your IRA contributions are generally tax-deductible from your ordinary income in the year of contribution. Your withdrawal of from your IRA is taxed as ordinary income. And that’s it. There’s no other tax related to your income tax deductible contributions and your income taxable withdrawals.

 

The only time there’s a possible chance of deducting a loss is when your IRA has a nonzero basis. And you have a nonzero basis in your IRA account only when you have made non-deductible contributions. The value of your basis is the total amount of non-deductible contributions. People who have only made tax-deductible contributions have no basis (i.e. ‘zero’ basis) in their IRA.

 

All earnings of your investments in your IRA – whether of tax-deductible contributions or nontax-deductible contributions grow tax-deferred until they’re withdrawn. Then they are taxed as ordinary income. But your basis is never taxed. Those who have only made tax-deductible contributions will have everything in their IRA liable to income taxation.

 

There’s no capital gains tax associated with withdrawing from an IRA account because ordinary income taxation takes care of all the taxation. You just have to keep track of your non-deductible contributions (i.e. your basis) so you don’t include that in the ordinary income taxation of earnings and deductible contributions.

 

There is a possibility, though of taking a tax deduction – against your income tax - for a loss on your IRA account, but that occurs only if the total amount you can withdraw from your IRA is less than your basis.

 

The rule: Your basis in your IRA is assumed to be withdrawn last

When you withdraw money from your IRA, all tax-deferred earnings and tax-deductible contributions are assumed to come out first. So, your basis which is the total of your non-tax-deductible contributions, comes out last. And that refers to all your IRAs together. There’s nothing you can do about this.

 

So from a tax deductible point of view, only when you withdraw all your IRA value and that amount is less than your basis, will you have a loss you can deduct. This makes it difficult to get a deduction. Here’s the procedure…

 

 

 

Procedure for deduct an IRA loss

First, you need to withdraw everything you have in all your traditional IRAs if your loss is in one of them. That ends your IRAs!

 

Second, what you’ve withdrawn must be greater than your current basis in your IRA. That’s because a loss represents receiving less value than your basis.

 

Let’s consider an example:

At the beginning of the tax year, Bill has an IRA with a balance of $24,000. His basis in it is $15,000. But during the year his IRA investment balance dropped by almost 50% to $13,000 after a severe crash in some stocks he was holding. So the value of his IRA dropped $11,000 (= $24,000 - $13,000)

 

What can he deduct for losses?

Well, the $11,000 loss ate up $9,000 (= $24,000 - $15,000 basis) of his tax-deferred earnings, as well as $2,000 into his basis of $15,000.  So he could claim a $2,000 loss. And No, he can’t deduct the $9,000 of investment loss.

 

But to get that $2,000 loss, he needs to withdraw all is IRA money – because that’s what constitutes a ‘sale’. Assuming this IRA is all that he has, he’ll have to pull out the remaining $13,000 – i.e. empty his account. His loss is formally $2,000 (= $15,000 basis less $13,000 balance) according to scenario 1 in table.  See table for what happens when investment losses are less as in scenarios 2 and 3.

 

 

Scenarios:	1	2	3
Beginning of year balance:	$24,000	$24,000	$24,000
Basis in IRAs:	$15,000	$15,000	$15,000
Loss in Investment (balance):	$12,000	$9,000	$6,000
Balance at end of year:	$13,000	$15,000	$19,000
Withdraw all in account:	$2,000 loss	$0	$4,000 taxable income

 

 

Lastly, your IRA losses can be taken only as miscellaneous itemized deductions on Schedule A of Form 1040 and only to the extent they exceed 2% of adjusted grow income.

 

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com