Harry’s IRA accounts have been steadily growing. His investments generate dividend income and capital gains that are taxed as investment income.
In a taxable account, investment losses may be deducted as tax expenses; however, an IRA doesn’t permit this kind of claim.
Losses aren’t deductible
Losses in IRAs and similar tax-advantaged accounts typically don’t qualify for tax deductions due to their composition; their balances mainly consist of dollars that haven’t yet been taxed – such as pre-tax contributions and untaxed earnings – which means any potential loss would need to wipe out all after-tax contributions and untaxed earnings for it to count as an itemized deduction under Schedule A’s 2 percent of adjusted gross income limit.
However, you can take distributions from both Roth and traditional IRA accounts without incurring an early withdrawal penalty. One method involves pulling first from accounts with losses before moving onto accounts that have positive balances or are at least not in losses; this approach will minimize penalties.
Losses aren’t tax-free
Prior to the Tax Cuts and Job Act (TCJA), you could claim losses in an IRA by cashing out its entire balance; however, in order for any benefit from loss deduction to materialize, its value must have fallen below your nondeductible contributions (after-tax contributions) made over time.
If your IRA accounts were cashed out and their values fell below your contributions, any losses would qualify as deductions on Schedule A; but only if itemizing and exceeding the 2% AGI limitation. And even then it may or may not make financial sense from a tax perspective.
Rebalancing is the ideal way to manage losing positions in a taxable brokerage account. If your portfolio has too much invested in one asset class, economic sector or geographic region, selling losers and purchasing winners may help restore balance back into your desired mix of investments.
Losses aren’t tax-advantaged
Taxable accounts often impose tax liabilities when investments are sold, while in an IRA the impact is deferred until distributions from your plan or “distributions.” The IRS treats this type of withdrawal as a lump sum and only counts gain or loss exceeding adjusted basis as income tax owed.
Loss rules used to apply differently between traditional IRAs and Roth IRAs. With nondeductible contributions made directly to traditional IRAs not having any basis, losses were only recognized once all nondeductible accounts had been cashed out.
Roth IRAs provide automatic contributions with a tax basis; this made recognizing losses easier as you didn’t need to liquidate all Roth and traditional IRAs of similar type at once. Unfortunately, this rule was eliminated by TCJA; until Congress acts again to restore it you may still recognize your losses by reallocating assets within your IRA plans.
Losses aren’t a wash sale
Wash sale regulations can be complicated and breaching them can be expensive. At TD Ameritrade, we’re happy to explain these regulations and assist in making necessary tax adjustments – contact client services any time if you have questions!
One benefit of IRA accounts is diversifying your investment portfolio by holding onto securities that aren’t performing as well, helping reduce risk by not overly concentrating in one asset class, economic sector or geographic region. But what happens if one of those investments suffers a loss? Some traders might assume a wash sale can offset that loss; unfortunately this isn’t possible; any loss must first be deducted in your taxable account and itemized on Schedule A to qualify as tax deductible, though even then it might not always qualify.
