Value of Roth IRA drops significantly. Income/loss recognition?

[Guest tmocpa]

I have had two situations this year where the value of clients converted Roth IRA has dropped significantly. In one case, the conversion was made at $30,000 of value, reporting $7,500 of income per year for 4 years and now in year two, the total value of the Roth is $9,000. Does the taxpayer still have to report the full $30,000, and when, if at all, does the taxpayer take a tax loss and, if so, what type of loss would it be. I see no discussion of this type of situation in any literature.

[John G]

If I understand the question correctly, you are describing a situation where the value drop was in the second year after a conversion. I have seen no information that would suggest that a Roth IRA can be reverted (recharacterized) after the first year (tax filing date) has expired. Recharacterization was originally designed to solve the problem of a late determination that a tax payer did not meet the income qualification for a conversion. Although this procedure allows some gaming of asset valuation flucuations, those actions must be related to the conversion year, and are now limited in frequency.

It sounds like your two cases involve non-diversified investments... perhaps some tech and dot.coms. There are lots of folks who chased those great returns and are now realize it was a speculative bubble.

[JAMES PATRICK]

First I think you may have a problem with the conversion if it was not made in 1998. Only conversions made in 1998 were eligible for the 4 year spread of the income. Conversions since then must have all income reported in the tax year that the conversion was deemed to have been made in.

Recharacterizations for 1998 conversions expired on Dec 31,1999; for 1999 they expired on Oct 16,2000 and for 2000 conversions, the last day to recharacterize is Oct 15,2001.

PUB 590 has details

[JAMES PATRICK]

If the conversion was made in 1998, your client still has to report $7500 for year 2000 and $7500 for year 2001.

There is no present way to take losses in a Roth as you have described this situation. I have heard that some changes are being considered to change that but I have my doubts. Your earnings in a Roth under the scenario that you don't withdraw until after 59 1/2 and 5 years in the Roth would never be taxable, so why would the IRS be willing to split your losses while not taxing your gains?

[Guest tmocpa]

Jim

Sorry for the confusion, conversion was made in 1998, 1999 was year two but return was extended and filed in October. What if person converted large IRA in ROTH (say $750,000, report income over 4 year spread and IRA never again reaches $750,000? Do you think there is a loss somewhere?

[BPickerCPA]

Upon termination of a Roth IRA where the total withdrawal is less than the tax basis, there is a loss which is taken on schedule as a 2% itemized deduction.

In the case of a 1998 conversion you still have to report the income for years 2000 and 2001.

[Mary Kay Foss]

At a meeting between the California CPA Society Tax Committee and the IRS a similar question was asked. (These questions and answers are published by CalCPA and the IRS is aware of that, but I'm not sure of the value as precedent). I'm going to repeat that question and the IRS response:

Question:

During 1998, a taxpayer converts a traditional IRA into a Roth IRA and pays the coversion tax. The taxpayer now has basis in the Roth IRA. Six years later, the fair market value of the assets in the Roth IRA decreases below the basis. At what point, if any, can a loss be claimed?

Response:

If a taxpayer has received all contributions and earnings from all their Individual Retirement Arrangements (IRA) and the total amounts received are less than their basis in all IRAs, the difference may be considered a loss (see Notice 89-25, 1989-1 C.B. 662, Q&Q 7).

Please note that all IRA's, both regular and Roth, must be combined for purposes of this determination. Regular IRAs are only combined with regular and Roth with Roth. In other words, excellent results in one Roth IRA may well offset losses in another. However, if your client has only a single Roth IRA, a loss may be recognized in the year in which the IRA is fully distributed. The loss would be claimed as an ordinary loss and deducted from gross income in arriving at adjusted gross income.

[John G]

Barry, are you saying that a Roth could be prematurely eliminated (withdrawn) to allow a tax payer to claim the loss? I would assume that the 10% early withdrawal would still apply, along with the 2% itemized deduction threshold, and the loss of the tax shelter. It seems you would need a pretty exteme case to make that worthwhile.

[BPickerCPA]

From Publication 590:

"Recognizing Losses on IRA Investments

If you have a loss on your traditional IRA investment, you can recognize the loss on your income tax return, but only when all the amounts in all your traditional IRA accounts have been distributed to you and the total distributions are less than your unrecovered basis, if any. Your basis is the total amount of the nondeductible contributions in your traditional IRAs. You claim the loss as a miscellaneous itemized deduction, subject to the 2% limit, on Schedule A, Form 1040."

Roth rules are the same as traditional IRAs except if specifically stated to be different in the law. I know of no specific part of the law stating that losses in Roths would be treated differently.

[BPickerCPA]

John,

That's exactly what I'm stating. Let's say that $20,000 was converted in 1998, and now the entire account is worth $2,000, in December, 2000. If taxpayer pulls out the $2,000 in 2000 and terminates the account (all Roths are aggregated so you can't just terminate one account if you have another), the taxpayer still has to report the $5,000 of 25% of the conversion income PLUS the acceleration of having withdrawn $2,000. Next year, the taxpayer still has to report the remaining $3,000 of conversion income ($5,000 less $2,000 acceleration). In addition, the taxpayer owes the 10% penalty on $2,000. But the taxpayer has an itemized deduction for $18,000, subject to 2% AGI limitation, and subject to AMT.

Barry

[John G]

Thanks Barry, I conclude that the rules you have specified means that tax loss rightoffs related to IRAs is a fairly remote prospect. No doubt some folks would like to cherry pick a single IRA account or single position (like a dot.com death) but the "all accounts" requirement eliminates that option.

So... if you are relatively new to IRAs, bet the farm on some internet miracle stock which is now down 95% you might have a partial deduction. But if you have multiple accounts or multiple holdings over many years... you have perhaps just completed a 3 credit and expensive elective from Nazdaq U.