Tax Deductions on Your Investments

This week, Gail opens her (voluminous) tax-related mailbag and answers questions about tax deductions -- in and outside of a retirement account.

My wife and I will file a joint tax return for 2002. We have a mutual fund investment that has lost well over $6,000. I know the limit in capital gains loss is $3,000, but if we are filing jointly can we declare $6,000 even if the investment is held in my name only?

Brad

Dear Brad-

This is something that trips up a lot of folks, so I'm glad you brought it up. First, don't forget that you can only deduct investment losses on mutual funds you have sold. If your mutual fund shares have gone down in value but you're still holding on to them, you cannot deduct your "losses". Also, the rule about deducting investment losses is that you can use ALL of the realized losses you have to offset (i.e. reduce), dollar-for-dollar, ALL of the investment gains you report.

In other words, if you had $10,000 in gains and also sold some investments that generated $10,000 in losses, you could zero out your investment gains.

The $3,000 limit for losses comes into play when you have more realized losses than gains.

Let's say you had $10,000 in gains and $25,000 in losses. In this case, you can use $10,000 worth of losses to reduce your taxable gains to zero. Of the remaining $15,000 in losses, $3,000 can be used to offset non-investment income (wages, for instance) on this year's tax return. This $3,000 limit is per return, not per individual. However, the remaining $12,000 in losses left over can be "carried forward" and used to reduce your taxable income in future years.

Sonya King is an assistant editor at the National Underwriter company, a major provider of tax and financial information. She says by virtue of the fact that you are married and filing jointly, it makes no difference whether the mutual fund was registered in your name only. "Your gains and losses are commingled by virtue of the very nature of the joint return."

Hope this helps,

Gail

Gail,

I read your article regarding selling losing stocks and taking the tax write-off. Does this apply to 401(k) accounts? I'm 44. In 1999-2000 I invested in a mutual fund that has gone from $50/share to $5/share. Can I move this to a new investment now and take the tax write-off?

Thanks,

Dan

Dear Dan,

Sorry. Just as you are not taxed on the gains your 401(k) has from year to year, you are not allowed to deduct any losses it might have, either. In a nutshell, there are no tax consequences -- good or bad -- for assets in a retirement plan until they are withdrawn. At that point, whatever amount you take out will be subject to ordinary income tax.

However, I would strongly suggest you take a hard look at the way your money is invested in your 401(k). I don't know how much of it was invested in the mutual fund that suffered the 90% loss, but that's serious. You need to do some honest self-evaluation about the amount of risk you are willing to take with your retirement money. Somehow, I doubt you would say that a loss of 90% is within your comfort range.

At the very least, make sure you are well-diversified among the investment choices available in your 401(k) plan.

Take care,

Gail

Dear Gail,

A couple of years ago I rolled over the small amount I had from a former employer's 401(k) plan into a regular IRA account, where I invested it 100% in a dot-com company that went bankrupt. That regular IRA account is now worth exactly zero.

Obviously, since this is an IRA, neither gains nor losses are shown on my tax return. I asked my broker whether I should just close the regular IRA account. I thought that by closing it I could then take advantage of the loss on my tax return without worrying about the early withdrawal penalty, since 10% of zero is zero.

My broker said he wasn't sure I could do that and he would find out for me. That was four months ago, and he hasn't gotten back to me. So, what do you think, Gail?

Sincerely,

Claire

Dear Claire,

You cannot take a loss on an IRA investment unless it was made with after-tax money. Since your dot-com stock was purchased with money rolled from a 401(k) plan, I'm assuming your 401(k) contributions were pre-tax.

Because you never paid tax on this money to begin with -- i.e. your 401(k) contribution was subtracted from your taxable income -- you cannot now declare a loss.

According to John Fenton, the resident IRA editor at National Underwriter, you can only declare a loss on an IRA if you have made after-tax (i.e. non-deductible) contributions. And, frankly, the process is often not worth the trouble.

To start with, you have to liquidate every IRA of the same type. In your case, you would have to cash out every one of your traditional IRAs. (If you wanted to take a loss on a Roth IRA, you'd have to liquidate all your Roths.)

Once you close your IRAs and total up the amount, you subtract the after-tax contributions you made. If your losses exceed your contributions, then you might -- might -- be able to deduct them.

Fenton says that's because an IRA loss comes under the heading of "Miscellaneous Itemized Deductions". These don't reduce your taxable income until the total exceeds 2% of your Adjusted Gross Income.

In your case, Claire, unless your 401(k) contributions were made with after-tax money, you have nothing to deduct.

Stay away from start-up companies with your retirement money!

Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.