|You may be able to claim a deduction for losses in
your Roth IRA..
to the Roth IRA
Roth IRA Losses
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
What Kind of
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
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
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
SITE MAP CONTACT
A publication of Fairmark Press Inc.
� Copyright 1997-2003, Kaye A. Thomas
All rights reserved