Previously, I suggested that taxpayers answer five questions before deciding to take money out of their IRA.
- Your age when the distribution was made,
- What type of retirement plan you have,
- How much you plan to withdraw,
- What the money will be used for, and
- What tax bracket you will likely be in?
- Will this money be withdrawn from the financial markets permanently?
- How much money has been lost?
- Is it better to take a loss deduction now?
That being said, taking a deduction for an IRA loss comes with some pretty big drawbacks. If the loss is sitting inside of a Roth IRA, then all Roth IRAs must be liquidated if you want to take the loss deduction. Similarly, if the loss is sitting in a traditional IRA, then all traditional IRAs must be liquidated if you want the loss. To make things even more complicated, only losses in nondeductible, traditional IRAs can generate losses. To further limit the usefulness of this strategy, the loss deduction is a miscellaneous itemized deduction subject to the 2% AGI threshold. Such deductions typically offer minimal tax savings due to the built-in limitations.
To get an idea of the kind of tax savings were talking about, let's take an example at random. Roger has Roth IRAs that have fared badly in the current market. He's contributed $12,000 to his Roth IRAs over the years, but his account is currently valued at only $9,000. So all told, he has lost $3,000 on his contributions. But both gains as well as losses are deferred inside a Roth IRA. If Roger distributes 100% of his Roth IRA, he could take a deduction for the loss. How much of a deduction he'll receive will depend on his adjusted gross income for the whole year, as well as his total miscellaneous deductions, and whether he's eligible to itemize. Let's assume Roger will be itemizing, that the IRA loss will be his only miscellaneous deduction, and that his AGI will be $100,000. The IRA loss is limited to the amount that exceeds 2% of his AGI. In other words, of Roger's $3,000 loss, only $1,000 will be tax deductible. If Roger is in the 28% tax bracket, this translates into a tax savings of $280.
Each person's scenario will be different of course, but the math is similar. The crucial question then becomes is the tax savings worth it for giving up the retirement account? Or, is it possible to recoup the losses through a better asset allocation strategy?