We all hope that our investments will produce profitable returns. But if they don't, there's the consolation of taking a tax deduction for the loss. In regular taxable investment accounts, reporting capital losses is pretty simple and straightforward. However, losses on investments in IRAs can be claimed only if certain stringent requirements are met.
- To claim a capital loss on IRA investments, you must empty that account—along with any other IRAs of the same type (e.g., traditional or Roth).
- You may deduct your traditional IRA losses only if the total balance that you withdraw is less than the after-tax amounts, or basis—that is, earnings, rollovers, and non-deductible contributions.
- IRA losses are reported as a miscellaneous itemized deduction subject to the 2% floor of adjusted gross income.
Withdrawing Balances to Claim Losses
To claim a loss on IRA investments, you must withdraw the entire balance from all your IRAs of the same type. For instance, if the loss occurred in a traditional, SEP, or SIMPLE IRA, you must withdraw the balances from all of your traditional, SEP, and SIMPLE IRAs (hereinafter collectively referred to as traditional IRAs). If the loss occurred in a Roth IRA, you must withdraw balances from all your Roth IRAs to include the loss on your tax return.
Traditional IRA Losses
You may deduct your traditional IRA losses only if the total balance that you withdraw is less than the after-tax amounts (basis amounts) in your traditional IRAs. Your IRA basis is attributed to nondeductible contributions and rollovers of after-tax amounts from qualified plans, 403(b) accounts and 457(b) plans.
You must file IRS Form 8606 to determine the basis of the amounts you withdraw from your traditional IRAs. Form 8606 also serves to indicate to the IRS which portion of your withdrawal is attributed to after-tax amounts and the amount that is eligible to be claimed as a loss on your tax return. Form 8606 and its accompanying instructions are available at www.irs.gov.
- Example 1 At the beginning of 2019, Tim's aggregate traditional IRA balance is $20,000, of which $15,000 is attributed to after-tax amounts. By Dec. 31, 2019, the investments in Tim's traditional IRAs lost $8,000, leaving his balance at $12,000. This amount is less than the basis amount of $15,000, so Tim may be eligible to claim a loss if he withdraws his total traditional IRA balance. His deduction would be the difference between the balance he withdraws ($12,000) and his basis.
Here is how the deduction is determined: $20,000 (Jan. 5 traditional IRA balance) - $8,000 (losses over the year ) = $12,000 (Dec. 31 traditional IRA balance) $15,000 (basis amount) - $12,000 (balance on Dec. 31) = $3,000 (deduction for traditional IRA losses).
Roth IRA Losses
The same rules apply to Roth IRAs: Claiming Roth IRA losses on your tax return is allowed only if the total of your Roth IRA balances is withdrawn and the amount withdrawn is less than the basis in your Roth IRAs.
Example 2 At the beginning of 2019, Tim's Roth IRA balances are $10,000, of which $6,000 is attributed to earnings and $4,000 is attributed to contributions. Since Roth IRA contributions are non-deductible, all contributions are considered after-tax amounts (basis amounts). During 2019, Tim's Roth IRA investments lost $2,000, leaving his balance at $8,000. This amount is more than the basis amount of $4,000; if Tim withdraws his entire Roth IRA balance, he will not be able to include the losses on his tax return: $10,000 (Jan. 5 Roth IRA balance) - $2,000 (losses) = $8,000 (Dec. 31 balance) $4,000 (basis amount) - $8,000 (balance on Dec. 31) = -$4,000 (no deduction).
Claiming the Loss
Taxpayers can claim the loss as a miscellaneous itemized deduction, subject to the 2%-of-adjusted-gross-income limit that applies to certain miscellaneous itemized deductions on Schedule A, Form 1040. Any such losses are added back to taxable income for purposes of calculating the alternative minimum tax. "Deducting IRA losses work best if you are older than 59½ to avoid the 10% early distribution penalty," says Dave Anthony, CFP®, RMA®, president and portfolio manager of Anthony Capital, LLC, Broomfield, Colo.
The Bottom Line
Be sure to consult with your financial advisor and tax professional before deciding to withdraw your IRA balances, especially if the sole purpose of making the withdrawal is to claim losses on your tax return. Your tax professional will be able to determine whether you are eligible to claim the loss. And your financial advisor should be able to assist you in determining whether it makes financial sense to withdraw all your IRA balances. Once they are out of your IRA, they will no longer be able to grow tax-deferred (for traditional IRA accounts) or tax-free (for Roths). He or she should also analyze your chances of recovering the losses in your IRA while you continue to enjoy tax-deferred or tax-free growth.
As an alternative, "an advisor can help you find other deductions that you may not be aware of that you could incorporate into your plans, such as charitable contributions, tax bunching, and advisor fees," Anthony says.