Investments can sometimes lose value. These losses can present challenges when your investments sit inside an individual retirement account (IRA). The main benefit of an IRA is that your savings can grow tax-deferred. But what happens when your investments are going down rather than growing?
It used to be you could get a tax break if your IRA lost money in the markets. That tax provision has been on hold since 2018. It might return in 2025, however, giving time to go back and amend a previous year's return.
- IRAs are structured so that any tax impact on investment growth is deferred until the money is withdrawn, usually in retirement.
- It's generally better to reallocate assets inside a plan than to take a distribution and reinvest the money outside the plan.
- Some IRA owners would rather pull money out to buy a home or pay medical bills. Both scenarios may lie outside the 10% penalty for early withdrawals.
- If you must, first pull money from IRAs with losses. Withdraw first from Roths, then nondeductible IRAs, then deductible IRAs if there's no overall loss.
Tax-Deferment Advantages of IRAs
IRAs are structured so that any tax impact on investment growth is deferred until the money is withdrawn from the account, usually in retirement. These withdrawals are referred to as "distributions." Tax treatment is determined when the distribution is made.
Any earnings, interest, dividends, or gains inside the IRA plan would not be taxed until distributions are made. The idea is to preserve this tax deferral as long as possible to allow your earnings to grow more rapidly than they might have in a taxable brokerage account.
Distributions aren't taxed at all if the account is a Roth IRA. Roths grow tax-free, subject to certain rules. That allows your earnings to compound without annual tax payments.
Defer Distributions Until Age 59 1/2
It's generally better to reallocate assets inside a plan than to take a distribution and reinvest the money outside the plan. The entire amount of any withdrawal you make from a traditional IRA is subject to a 10% penalty if you're under age 59 1/2. The withdrawal or distribution would also become part of your taxable income. This could push you into a higher tax bracket.
IRA Losses Used to Be Deductible
You once could take a loss on your IRA plans if you cashed out all your IRAs of the same type—traditional IRAs or Roths. That tax loophole ended with the 2018 tax year, but you might still be able to go back and amend a 2017 tax return in 2020 if you were unaware of this provision and didn't claim a deduction at that time.
You generally have three years from the date you filed your original return to amend it, or two years from the last date you paid any tax due on that return, whichever is later.
This loss provision worked for traditional IRAs only if you had a basis from nondeductible contributions. Basis means that you contributed post-tax dollars—you didn't claim a deduction for the contributions. There wouldn't be a loss that you could deduct on your tax return if there were no basis.
You couldn't cash out only your nondeductible IRAs—traditional IRAs for which you didn't claim a tax deduction for contributions you made. It might have worked out that way because you earned too much to qualify for a deduction. The end result is that you made your contributions with income on which you'd already paid taxes, much as you would with a Roth IRA.
Both your nondeductible IRA funds and your traditional IRA funds must be dissolved to qualify for the loss deduction. You must cash out all accounts of the same kind, and nondeductible and traditional deductible IRAs are the same type of account. Their contributions are just treated differently tax-wise.
The loss provision worked better with Roth IRAs, because there's automatically a basis for your original contributions. Contributions to a Roth aren't deductible in the first place.
Claiming the Deduction
Any loss you suffered would have been a miscellaneous itemized deduction subject to the 2% of adjusted gross income (AGI) threshold rule prior to enactment of the Tax Cuts and Jobs Act (TCJA) in 2018. The TCJA repealed miscellaneous deductions.
The TCJA is set to end at the end of 2025. So it's possible (although not guaranteed) that miscellaneous itemized deductions will return to the tax code at that time. Congress could renew the legislation, so this loss provision could return to the tax code.
IRA losses were subject to the 2% of AGI limitation prior to the TCJA. Your loss would have had to exceed 2% of your AGI for you to gain any benefit from this deduction. You had to itemize in order to claim it, reporting the loss on Schedule A. That means forgoing the standard deduction for your filing status.
The total value of a Roth or nondeductible IRA account could be cashed out, and you could take a deduction for the loss if the value of the IRA were to drop below your total contributions. The distribution would not have been subject to an early-distribution penalty in that case.
There wouldn't be a loss for tax-reporting purposes if the IRA lost value, but its value didn't dip below the total amount of contributions. It would generally be better to maintain the tax deferral on the gains you already have in that case.
Assets are permanently removed when they're withdrawn from a retirement account. You would only be able to contribute new funds.
IRA investors will want to take a look at their long-term asset allocation goals, along with any earnings projections.
Some IRA owners might not want to re-invest. They would rather pull the money out for non-investment purposes, such as buying a house, paying for medical expenses, starting a business, or covering living expenses. It might be necessary to create a strategy for early distributions in that case.
An exception to the 10% tax penalty for an early withdrawal before age 59 1/2 exists if you're buying a home for the first time or paying for medical expenses, but there are some limitations.
Tactics and Options
Consider first pulling money from IRAs with losses. Withdraw first from the Roths, then from nondeductible IRAs, then from deductible IRAs if there's no overall loss. These sequences provide the greatest way to keep penalties minimized.
You might also want to consider taking a loan against your 401(k) before taking an IRA distribution if your cash needs are short-term. You'd be lending to yourself, and the interest you'd pay would go back inside your 401(k) plan.
What works best for you depends largely on your specific investment and financial goals, coupled with a tax strategy that makes an IRA loss as cost-effective as possible.
NOTE: Tax laws change periodically. Always consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and is not a substitute for tax advice.