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Need Some Deductions for 2011?
Don't overlook these!
Updated for 2011
Tax Question
Q: I own various stocks in my IRA that have lost significant value. Can I deduct these losses?
A: The answer is NO if you have NO BASIS in your IRA and YES if you HAVE BASIS in your IRA AND have liquidated it (cashed it in). If you cash in your IRA and have basis in it, your loss is a realized loss as opposed to a paper loss, which is referred to as an unrealized loss.
Some Basics
For purposes of deducting a loss in a traditional IRA you must have what's called BASIS in the IRA and the loss must be a realized loss (as opposed to an unrealized loss).
There are two types of IRAs:
- Traditional IRAs
- Roth IRAs
Traditional IRAs:
With a traditional IRA, your contribution is not subject to federal income taxes. For example, say you get an $800 a week salary and contribute $50 a week out of your $800 to a traditional IRA. Your employer would exclude the $50 contribution from your gross pay, leaving only $750 subject to federal income taxes. However, the entire $800 is still subject to FICA taxes (social security and Medicare taxes); the contribution only escapes federal income taxes.
The $50 contribution to a traditional IRA is referred to as a before-tax contribution since it is not subject to federal income taxes at the time it is contributed. However, when you start receiving distributions from a traditional IRA, the distributions are subject to federal income taxes. You must include those distributions in your income and report them on Form 1040 along with any other income you received.
Roth IRAs:
Contributions to a Roth IRA are treated the opposite of traditional IRAs; the contributions are not deductible but the distributions are tax free. Roth IRA contributions are referred to as AFTER-TAX contributions since the contributions have already be taxed prior to making the contributions.
For example, if your weekly salary is $800 and your federal income taxes and FICA taxes total $230, your contribution to the Roth would come out your $570 net pay. You get no tax break for the contribution.
Terminology
To understand the rules, you need to understand some tax terminology.
- Basis
- Realized loss
- Unrealized loss
Basis
What the IRS says:
- BEFORE-TAX contributions to a traditional IRA have NO BASIS. This is because the contributions are not subject to federal income taxes. A loss related to such contributions, whether realized or unrealized, is not deductible.
Contributions to a traditional IRA, and subsequent earnings, are subject to income taxes only when distributed.
Note that, although contributions to a traditional IRA are not subject federal income taxes they ARE subject to social security and Medicare taxes.
Realized loss:
- A realized loss occurs when you liquidate your IRA (cash it in).
Unrealized loss:
- If you don't liquidate (don't cash in) your IRA after incurring a loss in value, the loss is referred to as an unrealized loss.
- In fact, for any investment that you own, such as stocks, bonds, and real estate, if the investment loses value and is worth less than your original investment, you may only deduct such loss if the investment is liquidated (sold) before you can claim (recognize) the loss on your tax return. Otherwise, the loss is simply a paper-loss and is considered an unrealized loss.
Example:
- Your weekly gross pay is $1,000.
- You open up a traditional IRA at your local bank.
- Your annual before-tax contributions total $2,000.
- At year-end your IRA declines from $2,000 to $800 for a loss in value of $1,200.
- You liquidate (cash in) your IRA at the end of the year and realize a $1,200 loss.
Result:
The $1,200 realized loss is not deductible because you have no basis in your IRA.
No part of your contributions were subject to federal income taxes.
When You May be Allowed to Deduct a Loss in Your IRA
Nondeductible contributions:
Nondeductible contributions have a tax basis. Nondeductible contributions are contributions in excess of the annual deductible limit.
If the liquidation value in your IRA is less than the amount of your nondeductible contributions, then you may deduct any loss that is realized.
For example, if your nondeductible contributions total $2,000 and you only get $1,000 when you cash it in (liquidate your IRA), you may deduct the $1,000 loss.
Reminder: Form 8606 must be filed to report nondeductible contributions to a traditional IRA. Contributions reported on this form are accumulated over the years and will equal your basis in the account.
Rule for Deducting Losses in Traditional IRAs
If you own one or more traditional IRAs you must close (liquidate) ALL of them in order to claim a loss.
This rule is designed to keep you from cherry picking the account(s) you want to close.
Roth IRA:
Contributions to a ROTH have basis but earnings in a ROTH do not. Therefore, if you liquidate your Roth and realize a loss, you must exclude the earnings when calculating the loss.
Like traditional IRAs, to claim a loss in a Roth IRA you must liquidate ALL your Roth IRAs, assuming you have more than one.
Where to Claim a Loss from a Traditional IRA or ROTH IRA on Your Return
The IRS does not allow losses from traditional IRAs or ROTH IRAs to be claimed as capital losses; do not report them on Schedule D.
Instead, report such losses on Schedule A as a miscellaneous itemized deduction subject to the 2% of adjusted gross income (AGI) rule. In other words, only the portion of the loss that exceeds 2% of AGI is deductible.
Furthermore, the amount of the deduction that exceeds 2% of adjusted gross income must be added to your taxable income for alternative minimum tax (AMT) purposes.