If you sell stocks with losses in your taxable accounts, you may offset losses against gains and deduct an additional $3,000 of excess losses against ordinary income. But what about losses in your individual retirement accounts (IRAs)?
First, keep in mind that you must withdraw the funds from the IRA before there are any tax consequences. The tax treatment of any losses on those distributions depends on whether you received a tax deduction for your original contribution. If you made deductible contributions to a traditional IRA, your distribution, including contributions and any earnings, is taxable as ordinary income. Thus, if your IRA has losses, you will withdraw a lesser amount, paying less income taxes. You get no specific benefit for the investment loss.
When non-deductible contributions are made to a traditional IRA, you pay taxes only on the earnings. Your contributions are withdrawn with no tax consequences. If your account balance is less than your total contributions, you may take a deduction for the difference, but only by completely liquidating all your traditional IRAs. The same is true with Roth IRAs.
You may deduct a loss when your account balance is smaller than your contributions, provided you completely liquidate all your Roth IRAs.
Those losses, however, are not deducted as a capital loss. Instead, they are a miscellaneous itemized deduction, subject to the 2 percent of adjusted gross income limitation. There are advantages and disadvantages to this tax treatment. On the plus side, this is a deduction against ordinary income, so you get the benefit at your marginal tax rate. Also, the deduction is not subject to the limit of $3,000 of excess losses offset against ordinary income, so you can deduct a much larger loss. On the negative side, you can only recognize this loss by itemizing deductions.
Because it is subject to the 2 percent limitation, you lose part of the deduction unless you have other miscellaneous deductions. If you are subject to the alternative minimum tax (AMT), you can't deduct miscellaneous deductions and could lose the deduction.
If the Roth IRA was converted from a traditional IRA, you could incur a 10 percent federal income tax penalty by liquidating before age 59 1/2 and before the fifth year after conversion. However, if you only made annual contributions to your Roth IRA, the 10 percent penalty may not apply, since it is only assessed on Roth IRA earnings. Since the value of the IRA is less than your contributions, you would not have any earnings.
Before implementing this strategy, you should carefully evaluate your tax situation to determine whether the tax benefits justify liquidation. Consult with your tax adviser.