By: Richard Feldman
By: Richard J. Feldman, CFP, MBA, AIF
How has your Roth IRA fared since the revolutionary retirement vehicle first became available in 1998? The stock market had a remarkable recovery in 2003 posting solid gains for most investors but some Roth IRA accounts are still way under water. What if I told you there were a way for the government to share in your losses. Would you be interested?
When the Roth IRA was first introduced in 1998 individuals were allowed to convert either the total amount or a portion of a traditional IRA and pay the tax on that conversion over a four-year period, if their adjusted gross income was under a $100,000. Many individuals took advantage of this option because paying the tax now on the conversion amount would allow the funds to grow and never be taxed again. The numbers and hypothetical illustrations always supported a conversion from a traditional IRA to a Roth IRA because individuals used straight-line growth and never accounted for the variability of equity returns.
Well here we are six years later and many individuals have suffered huge losses that they are never going to recoup. What should they do?
Liquidate your Roth IRA
IRS publication 590 states that if you liquidate all your Roth IRAs for an amount that’s less than your basis, you can claim a deduction for you loss. A Roth IRA has basis because you never receive a tax deduction for a Roth IRA contribution. The only money that is contributed to a Roth IRA is after-tax money. If you contribute after-tax money you have basis and if you empty an account and receive less than your basis, you have a tax loss.
Example: You converted $50,000 from a traditional IRA to a Roth IRA in 1998 paying the tax over four years. Now, in March of 2004 your Roth IRA is worth $10,000. Assuming you have no other IRAs and you withdraw the $10,000, emptying the account, you have a $40,000 tax loss.
The IRS says that this is a miscellaneous itemized deduction subject to the 2% floor. This means that you must itemize to be able to claim the deduction. If your itemized deductions are not larger than your standard deduction ($4,750 for individual filers and $9,500 for joint filers) than you won’t be able to itemize. A large Roth IRA loss such as the one in the above example, would allow you to itemize.
A miscellaneous itemized deduction must also meet the 2% floor. All of your deductions that fall into this category are grouped together and reduced by 2% of your adjusted gross income (AGI). If your AGI is $90,000 than you would reduce your miscellaneous itemized deductions by $1,800 (2% of your AGI).
If you converted your Roth IRA from a traditional IRA, liquidation of your Roth will result in a penalty of 10% of the distribution if you’re under age 59 ½ and the distribution occurs before the fifth year after the conversion. This means that 2003 became the first year for individuals to use a liquidation of a Roth IRA as a miscellaneous itemized deduction.
Alternative Minimum Tax
Miscellaneous itemized deductions aren’t allowed for purposes of the alternative minimum tax (AMT). This could cause you to lose part or all of the benefit of the deduction because of the AMT rules. (Please see article on AMT).
Is the Deduction Worth It?
If your Roth IRA hasn’t been devastated and you have a long time horizon than it probably is in your best interest to leave it alone and grow the account. Especially if the account has been earmarked for your children or grandchildren because a Roth IRA is one of the best vehicles to grow your money on a tax-free basis for your heirs.
But, if your Roth IRA is so underwater that it is unlikely that it will ever regain it’s initial conversion amount than liquidating the account and taking the loss more than likely makes sense. A number of factors have to be weighed before making a decision. Do you itemize? How large is the loss taking into account 2% of your AGI? Will it push you into the alternative minimum tax? As always, please consult your CPA, tax attorney, or tax advisor before making a decision.
****The above is for informational purposes and should not be considered tax advice.