As we're all painfully aware, the stock market hasn't been kind to investors in the recent past. Many folks are looking at their IRA statements, noting that the value of their accounts has been drastically reduced. This has brought up the question of losses in IRA accounts and whether they can be deducted. There has been much confusion when it comes to those losses. Let's see whether we can clear some of it up.

Losses vs. gains
Income and gains generated within an IRA account aren't immediately taxable. They don't have to be reported or disclosed anywhere on your tax return. Why? Because you'll report income on your IRA when you actually take distributions. This is especially true when dealing with a traditional IRA.

Distributions that you receive from your Roth IRA may or may not be completely tax-free, depending on a number of different circumstances. But the key is that any gains or income generated within the IRA account are not generally reportable or taxable.

But what about losses? The easy answer is that because the gains aren't taxable, the losses aren't deductible. That may be the easy answer, but it's not necessarily the correct one. In limited and unusual circumstances, losses from an IRA can be treated as a deductible loss.

Traditional IRA
If you have a loss in your traditional IRA, you can recognize that loss if, and only if: (1) the full amount in all of your traditional IRA accounts is distributed and (2) the total distribution is less than your basis in your traditional IRA account.

How do you get basis in your traditional IRA account? Only one way: by making nondeductible contributions to your traditional IRA account in prior years. If you have never made nondeductible contributions to your traditional IRA account, you don't have "basis" in the IRA. If you don't have basis in the IRA, you'll never have a deductible loss. A loss in value of your IRA is in no way deductible.

Let's take a look at some examples.

Example 1: In prior years, Tom has made $10,000 in deductible contributions to his traditional IRA. The value of the IRA today amounts to $1,500. This is the only IRA that Tom has, and he decides to take the distribution of $1,500. Tom's deductible loss on this transaction would be zero. Because Tom had no basis in his IRA (because all of his contributions were deductible), his distribution ($1,500) is still greater than his basis ($0). To add insult to injury, Tom would have to add the $1,500 distribution to his taxable income.

Example 2: Let's use the same facts as in Example 1 but add that Tom has another traditional IRA in which he has made $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. Tom closes both IRA accounts and takes distributions from them both. In this case, Tom's deductible loss would amount to $2,500, because the total distribution ($5,500) was less than his basis in all of his IRA accounts ($8,000). Also, Tom would owe no taxes or penalties on this distribution, because it's effectively a return of his 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, to a Roth IRA are considered nondeductible contributions. Thus, all of those contributions would add to the basis of the Roth IRA. Now, understand that if you take distributions out of your Roth IRA equal to your original contributions, you have removed your entire basis and the only assets remaining are considered earnings. In this case, you would again have no basis in your Roth IRA. But to make things simple, our example below will assume that no distributions have been taken.

Even though the chances of realizing a loss with a Roth IRA might be a bit better, the rules noted above remain the same. So, to deduct a loss related to a Roth IRA, you must ensure that (1) all of the amounts from all Roth IRA accounts have been distributed and (2) the total distributions are less than the unrecovered basis in the Roth IRA.

Example 3: Let's go back to Tom again. Assume the same facts as in Example 1, except that all of the contributions were to a Roth IRA account. That gives Tom $10,000 in basis in the Roth IRA. If he then takes a distribution from this Roth IRA account, and it's the only Roth IRA account that Tom has, he would recognize a loss of $8,500. The value of the account ($1,500) is less than his basis ($10,000) in the Roth IRA.

Again, it's very important to note that all of the IRA accounts would have to be distributed and closed to obtain a deductible loss from either a traditional IRA or a Roth IRA. You can't simply pick and choose the IRA account from which to claim a loss. It's an all-or-nothing situation.

What kind of loss am I?
So you have now determined that you have a loss in your IRA account. Where do you report it? Well, the news just gets worse and worse. You might think that you would be able to claim the loss as a capital loss on Schedule D, but that's not the case. The Internal Revenue Service takes the position that any allowable loss from either a traditional or a Roth IRA is only deductible as a miscellaneous itemized deduction, subject to the 2% of adjusted gross income (AGI) rule.

So let's again look at Tom in Example 3, and assume that he has $80,000 in AGI. A quick computation shows that he 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. And it could get even worse for Tom. What if he doesn't itemize his deductions? If he doesn't, it's possible that even the remaining loss would be less than his standard deduction (assuming that he's married), in which case the loss would actually be meaningless from an overall tax saving standpoint.

If you're trying to figure out a way to claim a deductible loss on your IRA account, either traditional or Roth, make sure that you know and understand the rules. You can read more about these rules in IRS Publication 590 and IRS Notices 87-16 and 89-25. Make sure you look before you leap.

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2002: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

August 20, 2004

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