I’m willing to bet that many advisers have clients who opened new IRA accounts over the last several years. These accounts are likely worth significantly less today than the total amount of original contributions due to the unprecedented market declines experienced over the last two months.
Is there any way to obtain at least some tax benefit from losses in IRA accounts?
Initially, one might think that there’s nothing that can be done to realize any tax benefits due to the losses in IRA accounts. But in fact, IRA account losses can be recognized and lead to tax benefits for the right kind of clients.
According to IRS Publication 590, taxpayers may recognize losses in both Traditional and/or Roth IRA accounts. However, the rules for recognizing losses are considerably different from the standard capital loss provisions, as one would expect.
Traditional vs. Roth IRA Losses
Claiming losses from a Traditional IRA is done by liquidating all Traditional IRA accounts and requires some basis in the accounts (e.g. non-deductible contributions). Any deductible contributions that are distributed may be subject to the 10% early distribution penalty. Considering the potential penalties and the low likelihood of clients with significant basis in Traditional IRA accounts, I won’t cover any of the details of claiming these losses.
Now to recognize losses in Roth IRA accounts, taxpayers must:
- distribute ALL amounts from all Roth IRA accounts, and
- itemize deductions on their tax return
With losses present in a Roth IRA, the distribution amount will, by definition, be less than the original contributions, so there will be no earnings distributed from the account. In other words, the account distribution will not be subject to the 10% early withdrawal penalty (remember, contributions that meet the 5-year holding requirement may be removed any time from a Roth IRA without penalty).
Claim Losses on Schedule A, not Schedule D
These losses, though, are not claimed as capital losses (on Schedule D of Form 1040). The recognized losses are claimed as a miscellaneous itemized deduction which are subject to the 2% AGI limit (on Schedule A).
In other words, recognized losses need to exceed 2% of a taxpayer’s AGI in order to gain any tax benefit. If taxpayers do not itemize deductions, then no losses can be claimed.
AMT Warning! Be careful; the losses claimed through this method are add-back items when calculating the Alternative Minimum Tax.
Rebuilding the IRA
So a client can recognize losses by liquidating all Roth IRA accounts and is eligible to receive a tax benefit through miscellaneous itemized deductions. Great, but what rebuilding the account in subsequent years? Liquidating a Roth IRA account to claim losses might be attractive, but it may take many years to replenish the account, depending on its size.
Contributions are currently limited to $5,000 per year (plus a $1,000 catch-up for taxpayers age 50 and older). In addition, Roth contributions can only be made when a taxpayer’s AGI is below certain thresholds (the 2009 phase out levels begin at $105,000 for single filers, $166,000 for married filing joint, and $0 for married filing single).
It can take many years of $5,000 contributions to rebuild a Roth IRA account, and it gets more difficult for clients who have above-average income and are affected by the AGI limits on contributions.
A Valid Strategy for Some
So while it is possible to gain some tax benefits from losses in IRA accounts, taxpayers are faced with quite a few hoops to jump through. Depending on the clients’ circumstances and all the conditions outlined above, harvesting losses in IRA accounts may prove to be a valid strategy, but it’s clear that the strategy is not cut out for everyone.
Related articles:
