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William Perez

Should You Cash Out Your IRA in a Down Market?

By November 4, 2008

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I've been asked this question by several readers, clients, and friends in the past few weeks. And I've taken some time to examine the issue from several points of view. The standard reply, of course, is not to over-react to market gyrations. But some people are facing dire financial hardships, and so it would be nice to know when to call it quits and completely liquidate an IRA account.

There's two things to keep in mind when evaluating such a move. First, will liquidating an IRA trigger the penalty for early distributions? Second, will IRA losses be tax-deductible?

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?
I've since decided that we also need to consider,
  • Will this money be withdrawn from the financial markets permanently?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?
In other words, I can understand that taxpayers might be faced with pressing financial decisions other than saving for retirement, and may need strategies to keep their tax bill under control.

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?

Comments
December 29, 2008 at 4:31 am
(1) Mik from AK says:

I have been in pain all weekend – staring at my investment statements with disbelief!… :)

I am contemplating closing down both our Roth IRA (my wife and I have one), and itemizing deductions for 2008 (I usually just take a Standard deduction). I have done a dirty estimate on Schedule-A and the losses from closed Roth IRAs (amount to total of $10,500) would bring the total of deductions about $3,000 higher than standard deduction (even with 2% AGI requirement).

So, in theory, I could have Roth IRA cash & tax loss write-off in hand. Why wouldn’t I do that, even if I wouldn’t need the cash? I know that I am limited to only $5000/year for future contributions into a new Roth IRA, but my employer is going to offer Roth 403b where the max is $15,500 next year. Also, I can probably do better homework with the cash and invest it better (let’s say Tax Free municipal bonds, which offer attractive rates right now).

Am I missing anything? Thanks

Mik

December 29, 2008 at 11:39 pm
(2) taxes says:

Mik, generally we advise people to avoid cashing out their retirement savings. But in this circumstance, I’m with you. It sounds like it would be better to cash out the Roth IRAs to take the loss, and then you could start afresh with new contributions. The only drawback to this is those funds are permanently removed from the IRA account. But as you said, you can probably find a better use for those funds, such as through munis.

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