By: Robert Gordon
By: Robert Gordon, MBA, CFP®, AIF®
This years challenging market environment presents investors with some unique opportunities to turn lemons into lemonade if the situation is right. Previously we talked about tax loss harvesting which is an exercise that allows investors to pocket capital losses that can be used against present or future capital gains or ordinary income. That activity is typically applied to taxable accounts. However, investors who own tax-deferred accounts like traditional and Roth IRAs may have a similar opportunity to realize losses and potentially reduce taxes.
The biggest challenge with taking losses on any type of IRA is taxed basis. I define taxed basis as amounts which have been contributed to the tax-deferred account after taxes have been paid. In a traditional deductible IRA or other deductible retirement-oriented savings plan, you do not typically have taxed basisbecause you have not paid taxes on the dollars in the account. However, if you made nondeductible contributions to a traditional IRA (nondeductible due to your income level for example) you do have taxed basisonly on those dollars since you contributed them after taxes were paid. The same is true for a Roth IRA. All the dollars contributed either through a Roth IRA conversion or through contributions are after tax dollars and therefore have taxed basis. Lets assume that you contributed $2,000 to a nondeductible, traditional IRA at the beginning of the year. Those were after tax dollars and so your taxed basis in the IRA is $2,000. If the value of the account should decline, you would have the opportunity to claim the loss.
Sound interesting so far? If you decide that this makes sense for your unique situation, be prepared for a complex, multi-step process. Importantly, the rules require that you liquidate all of your like-type accounts (i.e. all of your Roth IRAs or nondeductible traditional IRAs) not just the one(s) that may have a loss. Once liquidated, if the amount received is less than your ‘taxed basis (the total of your contributions including conversion contributions less any withdrawals,) you may be able to claim a deduction for the loss. The great part about taking this type of loss is that it can be applied against ordinary income which is taxed at your highest marginal rate and it is not subject to the $3,000 annual limit like capital losses. Of course, being an ordinary loss, it doesnt carryover to future years like capital losses. The deduction is only available if you itemize your deductions on Schedule A of the IRS form 1040. If you normally claim the standard deduction, with the severity of this years market decline, it may pay to consider itemizing to claim your IRA loss. In specific circumstances, the liquidation of the IRA dollars in question may not be subject to the 10% early withdrawal penalty since it would essentially be a return of your original investment. Lets look at an example:
At the beginning of 2008, Bill invests a lump sum of $4,000 to start a Roth IRA. That is his taxed basis . Bill is 35 years old and has over 30 years until retirement so he invests in an index-oriented portfolio with 80% in equities and 20% in fixed income. During 2008, Bils Roth IRA investments declined by $2,000, leaving his balance at $2,000.
$4,000 (Jan 15 Roth IRA balance)
- $2,000 (Decline in value)
$2,000 (Dec 31 balance)
Of course, as a miscellaneous itemized deduction, it is lumped together with other similarly categorized deductions and reduced by 2% of your adjusted gross income (AGI.) Assuming that this is the only miscellaneous deduction Bill has and that his adjusted gross income (AGI) is $50,000:
$50,000 x 2% = $1,000 (Calculate the reduction amount)
$2,000 (Realized loss on the now closed Roth IRA account)
- $1,000 (Miscellaneous deduction hurdle)
$1,000 (Deductible amount)
Importantly, for purposes of the alternative minimum tax (AMT), miscellaneous deductions arent allowed meaning that you could ultimately lose all or part of the benefit of the loss.
Aside from the obvious complexity and caveats of this strategy, perhaps the biggest drawback is being out of the market. Typically after a significant market decline there is a fairly sharp initial recovery. While no one knows when the recovery from this market downturn will come, missing the initial stages of that recovery will sacrifice a significant share of the long term returns. Importantly, if you decide to start back into a Roth IRA, your contributions are capped at the annual limit provided you meet the income guidelines. There are also limitations on the timing to start investing again in a like-type account (i.e. if you liquidate a Roth IRA, you cant start reinvesting in a Roth IRA for a specific period of time after the liquidation.)
Typically, the complexity and the drawbacks are deterrents to utilizing this strategy. As always, seek competent tax counsel regarding your specific situation. The Internal Revenue Services (IRS) Publication 590 on Individual Retirement Arrangements (IRAs) is available at www.irs.gov and it is an excellent resource for worksheet and rules regarding IRAs. For some, it could result in great savings and improve the after-tax returns. Of course, over the long term, a much greater success factor in reaching your goals will be the discipline and capacity to fund a long term investment plan that implements a globally-diversified portfolio designed for your risk tolerance and income needs.