This year's market weakness has been so extreme that it's hard to know what to say. How do you counsel patience and diversification when retirees have seen their nest eggs shrink by 30% or even more? How do you tell investors to stick with funds that have lost more than half their value in a span of less than a year?
I'll be writing more about how to pick up the pieces of your portfolio in the weeks and months ahead. The first step in the repair process is to take advantage of what I believe is a golden opportunity to do some tax-loss selling in your taxable accounts. I detailed the "how" of tax-loss selling a few months back, and last week I underscored the "why." Not only does tax-loss selling enable you to get rid of your losers, but you can also begin the process of getting your asset allocation back into whack AND offset as much as $3,000 in ordinary income on your 2008 tax return.
Tax-loss selling may be a no-brainer in your taxable accounts, but should you extend the process to your tax-sheltered holdings? The answer is not nearly so clear-cut. Yes, you can reap a tax benefit by selling your IRA, but those losses may not be as valuable to you as losses from your taxable accounts. In this article, I'll summarize the tax rules related to IRAs and 401(k)s, as well as the pros and cons of selling your IRA for tax reasons.
Tax Treatment of Tax-Sheltered Assets
Before getting into the merits of tax-loss selling in tax-sheltered accounts, it's important to understand the tax treatment of tax-sheltered assets in general.
With 401(k)s, 403(b)s, 457s, and IRAs, you'll never owe taxes on your investment activities from year to year, provided you confine your trading activities to those types of vehicles and you follow the rules on rollovers. That stands in contrast to trading within your taxable accounts. Activities that usually jack up your tax bill if you do them in your taxable accounts--such as holding high-income securities or high-turnover mutual funds or trading a lot yourself--don't have an impact on your tax bill if you conduct them within a tax-sheltered vehicle. That means that you're free to make whatever changes you need to make to these accounts without suffering tax consequences, presuming you follow the rules (to the letter!) about rolling over assets from one account to the next.
For that reason, you can and should take action to improve and upgrade your tax-sheltered portfolio on a regular basis. You can even switch investment providers for your IRAs, assuming you take care to make sure that the asset transfers are handled properly. (Your fund company or brokerage firm can help walk you through the particulars.)
Your only tax impact from holding tax-sheltered vehicles will be by having to pay taxes on your initial contributions--as is the case with Roth IRAs, traditional nondeductible IRAs, or Roth 401(k)s--or on your qualified withdrawals--as is the case with traditional IRAs and traditional 401(k)s. The latter types of vehicles are often called "tax-deferred," meaning that you can delay the taxes (that is, avoid paying taxes on income and capital gains on a year-to-year basis) but can't avoid them entirely. When you begin taking distributions from a traditional nondeductible IRA, you'll simply owe tax on any investment earnings you accumulated over the life of your account. For example, if you contributed $100,000 to your traditional nondeductible IRA over the years and your account value in retirement is now $300,000, you'll owe taxes on that $200,000 in appreciation. When you begin withdrawing assets from your 401(k), you'll owe taxes on both your contributions and investment earnings.
Are Losses in IRAs a Lost Cause?
So, just to be clear, you can never gain a tax benefit by selling losers from your 401(k). You can't take a loss on a traditional deductible IRA, either, because you already deducted your contribution on your tax return in the year in which you made it. You're certainly free to change your investments around in both types of accounts, but you won't receive a tax benefit for doing so.
But say you're one of the many individuals whose holdings in a Roth or traditional nondeductible IRA are now selling for less than you initially paid for them. Does that mean those losses are of no use to you at all? Not necessarily. It is possible to claim a loss on your IRA investments, assuming your basis is below your current account value, but there are some important distinctions between that type of selling and selling in your taxable accounts.
First, you can only deduct a loss on an IRA if you withdraw all of your assets from that IRA type, whether Roth or traditional, and your cost basis in all of those accounts is above the accounts' current values. If you've accumulated a sizable balance in a Roth or traditional IRA, that should be a big deterrent against selling, because future contributions will be subject to calendar-year contribution limits. Say, for example, you've got $20,000 in your Roth IRA now and your original contributions (or "basis") amounted to $24,000. In order for you to take advantage of the $4,000 loss, you'd need to liquidate all of your Roth IRAs and you'd only be able to put in new contributions of $5,000 in both 2008 and 2009 ($6,000 if you're older than 50).
In addition, those IRA losses may not be as valuable to you as are losses from your taxable accounts. Whereas losses from taxable investments can be deducted directly from your ordinary income on your income tax form, IRA losses are part of the miscellaneous itemized deductions you claim on schedule A of your form 1040. These deductions must amount to 2% of your adjusted gross income or they won't be usable. (Bear in mind that the 2% of AGI threshold can include other itemized deductions, including tax-preparation fees and some investment-related expenses.) You must also use these losses in the year in which you generate them. That stands in contrast with losses from taxable accounts, which can be carried forward from year to year if you don't use them.
As you've probably gathered, those with relatively small IRA balances that they're holding at a loss are the top candidates for taking a loss in an IRA, provided they can meet the IRS' 2% miscellaneous itemized deduction threshold. On the flip side, tax-loss selling is off-limits for those with traditional deductible IRAs, nor does it make sense for those whose miscellaneous itemized deductions don't meet the IRS' 2% threshold. In addition, those with large accumulated IRA balances (even if they are underwater) should think twice about selling, because it could take several years' worth of future contributions to get back to the same asset level your account is at right now.
Even if you do your homework and decide an IRA tax loss isn't in the cards for you, you can still rebalance and tinker with your IRAs so they're well positioned for the years ahead. In fact, because there are limited tax consequences for making changes, your tax-sheltered accounts should usually be the starting point for your rebalancing efforts. I'll discuss rebalancing in-depth in upcoming columns.