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I'm about to begin my retirement, but my 401(k) has plunged in value by more than 50 percent over the past three years. Can I take advantage of the capital loss provision to deduct those losses when I file my tax return?
-- Irene Todd, Charlotte, North Carolina
Sorry, but since the money you've invested in your 401(k) hasn't been taxed yet, you can't get a tax break on losses in your 401(k) no matter how much your 401(k)'s value drops. And, much as I hate to weigh in against a potential tax break, this makes perfect sense.
Let's say, for example, you invest $5,000 in a 401(k) and over the course of a year, your investment loses 40 percent, or $2,000. And let's say that you pull the $3,000 you have left out of your account. (For the purposes of this example, let's assume there's no early withdrawal penalty.) Assuming you're in the 25 percent tax bracket, that would mean you would owe $750 in taxes, leaving you with $2,250 after taxes.
What's happened? True, you didn't get to deduct your $2,000 loss against other income as you would with a $2,000 loss for an investment held in a taxable account. But you did get a tax benefit on the $2,000 loss.
How? Well, when you pulled the money out of the account, you were taxed not on the $5,000 you originally invested, but only on the $3,000 balance. Which means that $2,000 of income that would have been taxed was not taxed because you put that money in the 401(k).
In short, if you were also allowed to deduct the $2,000 loss, you would in effect be taking advantage of the loss twice. I'm all for tax relief, but even I think that would be going too far.
Theoretically possible -- but hardly practical
I should note that there is one way you theoretically could deduct a loss in your 401(k). If you made nondeductible (or after-tax) contributions to your 401(k) and your losses were so large that the amount you withdrew from your account was less than the amount you contributed with after-tax dollars, then you could take a deduction.
For that to happen, however, the value of all the pre-tax dollars you contributed, plus any match your employer made, would have had to fall zero, essentially leaving you only with whatever remained of your after-tax contributions. In other words, it's not bloody likely.
Rather than obsess over your 401(k) losses, I recommend that you think of ways to restructure your account so that you can: a) participate in the market rebound when it eventually comes; and, b) devise a reasonable withdrawal strategy so that your 401(k) assets, combined with Social Security and any pensions, can support you during retirement. For suggestions on how to do that, click here.
Don't forget, as long as you keep your 401(k) money in a tax-sheltered account, such as a 401(k) or rollover IRA, you'll still be able to shelter future gains from taxes, which can be a distinct advantage in rebuilding the value of your account.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged."