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The bright side of worthless stock
Stock in my IRA has become worthless. Can I get a tax break on the loss?
July 19, 2005: 11:32 AM EDT
By Walter Updegrave, CNN/Money contributing columnist

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NEW YORK (CNN/Money) - I have stock that I own in an IRA account that has essentially become worthless. I understand that you can take a loss for worthless stock in a regular account, but do I qualify for any kind of a tax break if it's held in my IRA?

-- A.H., Dulles, Virginia

You're right that you can take a capital loss if a stock you own in a regular brokerage account becomes worthless. And the ever helpful IRS tells you all you need to know to do that in the Worthless Securities section of good old IRS Publication 550: Investment Income and Expenses (Including Capital Gains and Losses).

But your chances of deducting a loss for a worthless security are pretty small if you hold the stock in a IRA account. That may seem like petty discrimination on the IRS's part against poor IRA investors. But, in fact, denying a tax write-off for losses in IRA accounts -- whether due to a security becoming totally worthless or just dropping in value -- makes perfect sense when you think about it.

An example

Let's say, for example, you buy 100 shares of The Next Microsoft Corp. for $10 a share in your IRA. But, alas, instead of living up to its promising name, the company turns out to be more like the next Enron and its shares become totally worthless. You've lost $1,000.

But do you deserve a tax write off? The answer is no for this reason: Presumably, when you put this stock in your IRA you took a $1,000 tax deduction. That means that a $1,000 of your income wasn't taxed because the deduction lowered your taxable income by $1,000.

Indeed, even if you had originally bought the stock in a 401(k) and later moved it to an IRA rollover account, you still avoided paying tax on the $1,000 because you're contributing pre-tax dollars to your 401(k).

Of course, when you pull that $1,000 from your IRA, that money plus any earnings are then taxed. But if the stock has become worthless, there is no thousand dollars or any earnings to withdraw. Hence, you pay no tax. Remember, though, you still got a tax break on your original $1,000 contribution because that money did represent taxable income and you didn't pay tax on it.

If you were also allowed to deduct the $1,000 as a loss, you would be getting two tax breaks for the same thousand bucks: the first when you made the contribution to the IRA and then another when you were allowed to write off the $1,000 again.

Put another way, you would be effectively be getting $2,000 worth of deductions on $1,000 worth of income. Even I, someone who believes we would all be better off if taxes were lower, think that's a bit excessive.

There are ways to deduct IRA losses

That said, it is possible to deduct losses in an IRA. To do so, however, you would have to have made nondeductible (that is, after-tax) contributions to your IRA in addition to any deductible contributions. And the losses would have to be large enough so that when you withdraw all your money from all your IRA accounts (excluding Roth IRA accounts, if you have them), the amount you received exceeded the value of your remaining nondeductible contributions.

Which essentially means the loss would have to wipe out whatever is left of your original tax-deductible contributions in your account plus all earnings in the account.

I don't think this is a very likely occurrence for most people. But if you want to learn more about the rules for deducting losses in IRAs (and Roth IRAs, for that matter), you can check out IRS Publication 590: Individual Retirement Arrangements (IRAs).

One final caveat: if you plan on reading IRS Publications 550 and 590 in one sitting, I strongly recommend that you let at least two days go by before you drive or operate heavy machinery.

For more about deducting losses, click here.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."  Top of page


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