Guide to the Roth IRA

Roth IRA Losses

If you've lost money in your Roth IRA, you're not alone. In a sour stock market there's plenty of pain to go around, and some investments have lost value dramatically.
    If your Roth loses money shortly after you converted from a traditional IRA, your best choice is probably to undo the conversion. After waiting long enough you can convert again, assuming you still qualify for a conversion. Usually the lower value of the account means you'll pay a smaller tax on the second conversion. DETAILS
    But what if it's too late to undo the conversion? That's especially painful for people who converted in 1998 and spread the income over four years. Here it is 2001 and you're still paying tax on the original conversion amount � even though market losses have decimated your IRA. There's nothing like having to write a check for $5,000 in taxes as the fourth installment on the 1998 conversion when the entire IRA is now worth only $3,500.

Loss on Liquidation
Ordinarily, distributions from a traditional IRA are taxable, so the tax "benefit" when your account loses value is that you report a reduced amount of income rather than claiming a loss deduction. Yet if you've made nondeductible contributions to a traditional IRA, you recover those contributions � your IRA's "basis" � free of tax. If your account ends up with a value smaller than its basis, the IRS allows a deduction, but only if you completely liquidate all your traditional IRAs.
    For technical reasons, it hasn't been clear that this deduction is available for Roth IRAs. The new (2001) version of IRS Publication 590 gives the answer: if you liquidate all your Roth IRAs for an amount that's less than your basis, you can claim a deduction for your loss. Your basis is the amount of your contributions to the Roth, including conversion contributions, reduced by any amounts you've withdrawn.

What Kind of Deduction?
You might expect to get a capital loss deduction in this situation. After all, in most cases the IRA lost value because stocks, mutual funds or other investments in the IRA declined. Instead, the IRS says this is a miscellaneous itemized deduction that's subject to the 2% floor. Here's what that means.
    On the good side, this is an "ordinary" deduction rather than a capital loss. That means the $3,000 capital loss limitation doesn't apply, and the deduction counts against income that's taxed at the highest rate that applies to you.
    There's a drawback, though. The deduction is available only if you itemize. If you normally claim the standard deduction, it may pay to consider itemizing to claim your IRA loss. But if your loss isn't big enough, you might still be better off with the standard deduction, and that means you get no benefit from liquidating your IRA.
    And there's another drawback: the 2% floor. All your deductions that fall into this category of "miscellaneous" itemized deductions get lumped together and reduced by 2% of your adjusted gross income (AGI). If you don't have other miscellaneous deductions, the entire 2% reduction comes out of your IRA deduction.

Example: You converted a traditional IRA when it was worth $5,000 and now it's worth $1,500. Your AGI is $90,000. If you liquidate the Roth for a loss of $3,500, you'll have to reduce that amount by $1,800 (2% of your AGI), leaving you with a deduction of only $1,700.

And there's another drawback. Miscellaneous deductions aren't allowed for purposes of the alternative minimum tax (AMT). That means you could lose the benefit of the deduction (or some of the benefit) because of the AMT rules. This type of AMT situation doesn't give rise to an AMT credit you can recover in future years, so any part of the deduction that gets swallowed up in the AMT is lost forever.

Liquidating Your IRA
To qualify for the deduction for losses in a Roth IRA, you have to liquidate all your Roth IRAs. You can't claim a loss on one Roth while keeping another Roth in place, even if all the loss occurred in one Roth. The same rule applies to traditional IRAs where the value is less than your basis. However, you don't have to liquidate traditional IRAs to claim your loss in a Roth, or vice versa.
    Bear in mind that if you converted from a traditional IRA, liquidation of your Roth will result in a penalty equal to 10% of the distribution if you're under 59� and the distribution occurs before the fifth year after the conversion (2003 for conversions in 1998). If your account still has substantial value, you may want to delay liquidation of a conversion Roth IRA even though this will delay your deduction. You don't have to worry about this if your Roth has only annual (non-conversion) contributions because the penalty for that type of Roth applies only to earnings. A Roth isn't considered to have earnings if the value has decreased, even if the Roth received amounts like interest and dividends that would normally be considered earnings.

Is It Worth It?
Whether it makes sense to liquidate your Roth to claim this deduction depends on many factors. Do you itemize? How large is the loss compared with 2% of your AGI? How much do you lose by removing what's left of your account from the Roth IRA, where it has the potential to produce tax-exempt earnings? Will you incur a 10% penalty if you liquidate now? You may want to consult with a tax professional, but bear in mind that you have to act soon enough to liquidate the account by December 31 if you want to claim a deduction this year.

by Kaye Thomas    
July 19, 2002    

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