Deducting your IRA losses

Q: I have made some lousy investment decisions in my IRA account in recent years and I now have losses in the account. My IRA is now worth less than the sum of my nondeductible contributions. If I take the money from my IRA, will I have to pay taxes on it or will I be able to claim my loss?

A: Distributions from retirement accounts, including IRA accounts, are taxable to the extent that the amount of the distribution exceeds the tax basis. In your situation, the tax basis in your IRA account is the sum of each year's nondeductible contribution. If you contributed $2,000 each year for 10 years, then your total contribution would be $20,000 and your tax basis would also be $20,000.

If the value of your IRA had grown to $30,000 and you withdrew the entire amount, you would have to pay tax on $10,000 — the difference between the amount you took out and your basis. If you had been able to deduct your $2,000 contribution each year, then your tax basis would be zero and you would have to pay tax on the full $30,000.

But what happens when the amount that remains in your IRA account is less than your tax basis? You might be able to deduct the loss if you follow certain rules, which I will illustrate in the following example: Let's say you made nondeductible contributions in the amount of $2,000 every year for ten years, totaling $20,000. Today, your IRA account balance is $12,000 and you withdraw the entire amount. Potentially, you have an $8,000 deductible loss.

Here are the steps you must take to claim it:

  • You must withdraw all the money in your IRA account (and if you have more than one traditional IRA account, you must withdraw all the money from those accounts, too). The IRS says you can't take some of the money out and prorate the loss because they don't think you can accurately establish the amount of the loss until you have withdrawn all money from your IRA.
  • If the total amount you take out is less than your total tax basis in the account, then you have a loss that you can claim on your tax return. In your case, all the money you contributed to your IRA account was included in the tax basis of that account because you paid income tax on all the contributions.
  • When you prepare your 2012 income tax return, you will report the $12,000 withdrawal on the front page of your Form 1040 as the gross amount of your IRA distribution. On the same line, you will report a taxable amount of zero.
  • The IRS requires you to claim your $8,000 loss as an itemized deduction. If you don't usually itemize, you should try it this year.
  • You report the loss as a miscellaneous itemized deduction subject to the limit of 2 percent of your adjusted gross income. So you add the $8,000 loss generated by your IRA to your other miscellaneous itemized deductions (e.g. tax preparation fees, deductible employee expenses, deductible investment expenses, etc.). Then subtract 2 percent of your adjusted gross income from the total of the miscellaneous deductions and include the result in your itemized deductions.

Kenneth B. Petersen is an investment adviser and principal of Monterey Private Wealth, Inc., in Monterey. Send questions concerning investing, retirement or estate planning to 2340 Garden Road, Suite 202, Monterey 93940 or ken@montereypw.com