Roth IRA Losses

Ed Slott & Company

Whether it makes sense to liquidate your Roth IRA depends on many factors.

Posted July 21, 2009

By Ed Slott & Company

If you have lost money in your Roth IRA, you are not alone. We have had three years of a sour stock market, despite a recent modest recovery. If your Roth IRA loses money shortly after you converted from a traditional IRA, your best choice may be to undo the conversion. To undo you would recharacterize by no later than October 15th of the year following the conversion. Then you can elect to convert again the later of January 1st of the year following the year of conversion, or 30 days after the rechacterization. Usually the lower value of the account means you will pay a smaller tax on the second conversion.

However, if you cannot recharacterize and want to realize a loss for income tax purposes you must liquidate all of your Roth IRAs. The loss is determined by your basis. Your basis is the amount of your contribution to the Roth IRA, including conversion contributions, reduced by any amounts you have withdrawn. Generally when you sell a stock outside of an IRA for a loss you would be entitled to a capital loss deduction. When you liquidate a Roth IRA for a loss the loss will be a miscellaneous itemized deduction that is subject to the 2% floor. This means it is an ordinary deduction rather than a capital loss. The deduction is, however, only available if you itemize.

The 2% floor mentioned above means that all your miscellaneous itemized deductions get lumped together and reduced by 2% of your adjusted gross income (AGI). There is another possible drawback. Miscellaneous deductions are not allowed for purposes of the alternative minimum tax (AMT). That means you lose the benefit of the deduction (or some of the benefit) because of the AMT rules.

Here is an example:

You convert a traditional IRA when it is worth $5,000 and now it’s worth $1,500. Your AGI is $90,000. If you liquidate the Roth IRA for a loss of $3,500, you will have to reduce that amount by $1,800 (2% of your AGI), leaving you with a deduction of only $1,700.

Whether it makes sense to liquidate your Roth IRA to claim this deduction depends on many factors. Do you itemize? How large is the loss compared with the 2% of your AGI? How much do you lose by removing what’s left of your account from the Roth IRA, where it has the potential to produce tax-exempt earnings? Will you incur a 10% penalty (prior to age 59 1/2) if you liquidate now?

This can be a complicated decision, so you may want to consult with a tax professional before making a decision.

Ed Slott and Company has been called "The Best" sources for IRA advice by The Wall Street Journal, and "America's IRA Experts" by Mutual Funds Magazine. Ed is a widely recognized professional speaker and author. The company’s website is IRAHelp.com.