To encourage investment, the tax code provides an incentive to soften the blow of a loss
Dear Dan,
I have had carryover losses for years now, only being able to deduct $3,000 a year and still have a lot of losses to deduct going forward. If I make an IRA withdrawal, can the tax on this withdrawal be offset by the carryover losses I still have? I’m over 59.5 years old, so I don’t have to pay a penalty for the IRA withdrawal. Thanks for your help.
—Carryover Curious
Dear Carryover,
Investing comes with risk. To encourage investment, the tax code provides an incentive to soften the blow of a loss. When an investor sells a holding for a loss in a taxable account, that loss can be used to offset other taxes.
It is unlikely the loss will help much with taxes on the IRA distribution. Capital loss carryforwards are required to be used first to offset capital gains during the year. If there are still losses after accounting for the gains, up to $3,000 of capital loss can offset the total of all ordinary income received from all sources.
Distributions of pretax funds from IRAs are taxed as ordinary income, not capital gains. Conversions of pretax IRA funds to a Roth IRA are likewise treated as ordinary income.
If you receive $3,000 or more of taxable ordinary income from other sources like interest, wages, Social Security, or pensions, the $3,000 would have already been used to offset that income. Hence, none of an IRA distribution will be offset by the capital loss.
If you have little ordinary income from other sources, capital losses might offset an IRA distribution or conversion. Say you make just two transactions in a taxable account resulting in a $5,000 long-term gain on the sale of one security and a $20,000 loss on the sale of another. In addition, you have no other income and pull $30,000 of pretax money from your IRA.
There is a net capital loss of $15,000 ($5,000 – $20,000 = ($15,000)). Only $3,000 of that loss flows through to the tax return and is reported as a loss. The $30,000 IRA distribution is reported as part of line 4b and the ($3,000) will appear on line 7, “Capital gain or (loss)”. When it is all added up, the net is $27,000 taxable as ordinary income.
The remaining $12,000 of losses in the example carries forward into the following year to be used against that year’s gains. If no gains are incurred that year, $3,000 of the loss carryforward appears, on Line 7 and the remaining $9,000 carries forward to the next year.
This carryforward function is what you are dealing with. One bit of good news is that the capital loss carryforwards do not expire until you do. If you are married, your surviving spouse may be able to use some of the losses going forward but that’s a separate issue beyond the scope of this column.
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Originally published on MarketWatch. Read the original article here.