The general tax rule is that market losses in retirement accounts are never deductible. That statement is true, but as with everything relating to the taxes, there’s a “but.”
In rare circumstances, you might be able to deduct losses from these accounts.
Basic Requirements for All Types of Accounts
- All accounts of the same type must be fully paid out. For example, if you have 3 IRAs, all 3 accounts must be fully paid out.
- You must have after-tax basis. This means amounts put into the account with after-tax dollars. With Roth IRAs, your basis is whatever you have paid into the account. In traditional IRAs and 401(k) plans, your basis would be any non-deductible contributions you have made. Most 401(k) plans will never have non-deductible contributions in them.
The Mechanics of Figuring the Deduction
Assuming you meet the above two requirements, you then have to calculate your loss. To do this, you take the amount of cash you receive and compare it to your basis. If the cash received is less than your basis, you are eligible for a deduction.
Example: You close out a Roth IRA account. It is the only Roth IRA you have. Through the years, you paid in $5,000 into the account. You received $4,000 when you closed out the account. The amount of loss eligible for a deduction is $1,000 ($4,000 received minus $5,000 basis).
Hurdles to Clear
In the example above, you are still not in the clear for taking a $1,000 deduction. Tax law puts three hurdles in place that make it hard to actually take the deduction.
- Hurdle #1: losses on retirement accounts are not considered capital losses. Instead, they are considered miscellaneous itemized deductions. This means: you only get the deduction if you itemize deductions.
- Hurdle #2: because it’s a miscellaneous itemized deduction, the amount of the loss has to exceed 2% of your income in order to be deductible.
- Hurdle #3: Only the portion of the loss that exceeds 2% of your income can be taken as a deduction.
Example: continuing with the above example of a $1,000 loss – if your income is $40,000, you take $40,000 x 2%, which equals $800. You subtract $800 from the $1,000 loss, which equals $200. You can put $200 as an miscellaneous itemized deduction on your tax return.