'Lock in losses'? Go for it

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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NEW YORK (Money) -- Question: . I was laid off recently and want to roll over the substantial balance in my 401(k) into an IRA. But I don't know whether to do the rollover now and risk locking in losses or wait until the market recovers and then roll it over. What do you think?  Steve, Wichita Falls, Texas

Answer: This phrase "locking in losses" is one that gets tossed around a lot these days. And most of the time I hear it, I get the impression the people using it are afraid they'll be violating some sacrosanct investing rule by not holding onto depressed investments until they regain lost ground.

Considering that so many people have taken major hits in the value of their retirement and other investment accounts, I thought answering your question might clear up some of the confusion.

Let's start with your situation. Essentially, it makes no difference whether you roll over your account balance to a 401(k) or you wait until the market recovers and then do the rollover. A little example will show why.

Let's say, just to keep things simple, that your 401(k) consists of a Standard & Poor's 500 index fund that had a value of $100,000 a year ago, but is now worth $60,000. Well, if you roll over the balance now, you would indeed be liquidating your S&P 500 fund for $40,000 less than its value a year ago.

But what does that mean for your portfolio? Actually, nothing. If you reinvest your $60,000 balance in another S&P 500 fund in an IRA, you'll be in the same position you were in with the 401(k). You will have $60,000 invested in an S&P 500 fund.

In order for you to get back to your $100,000 balance, the fund has to gain 67%. That's true whether you leave your money in the 401(k) or move it to an IRA.

So from a pure investing standpoint (assuming both the 401(k) and IRA have similar fees), there's really no reason to hold off moving your money now.

In fact, even if you're thinking of investing your money differently -- say, dividing your $60,000 equally between an S&P 500 index fund and a bond fund -- there's no reason to hold off. Either way you would still have $30,000 in an S&P 500 fund and $30,000 in a bond fund, and you would earn the same return whether you held those funds in the 401(k) or IRA.

Keeping your money in the 401(k) might make sense if the fees are lower or because you plan to quickly move the money to your next employer's 401(k) and don't want to deal with the hassle of rolling the balance into an IRA and then into your next 401(k). But "locking in losses" really isn't a consideration.

That's not the case, however, if you are dealing with investments held in a taxable account as opposed to a 401(k) or IRA, since you could have a loss for tax purposes that you may be able to turn to your advantage. (It's much harder to come by such tax losses in 401(k) and IRA accounts and even harder to deduct them - See 'Deducting your IRA losses'.)

So, for example, if you had invested $100,000 in an S&P 500 fund in a taxable account a year ago that is now worth $60,000, selling that fund would give you a $40,000 investment loss. You would then be able to lower your tax bill by using that loss to offset investment gains in other investment accounts and possibly even applying it against ordinary income.

Granted, you would have to follow a bunch of nitpicky little IRS regs. And in particular you would want to be sure not to run afoul of the dreaded "wash sale" rules that disallow all or part of your investment write-off if you sell a security for a loss and buy the same or a substantially identical one within the 30 days before or after the sale.

But in a case where you're sitting on securities that are worth less than you paid for them, it would clearly be worth your while to "lock in your losses" in order to capitalize on the tax break.

There's one final aspect of this phrase "locking in losses" that I think deserves attention. A lot of times I'll hear people express reservations about selling an investment at a loss because they desperately want to "get back to even."

Whether it's because they're afraid they'll miss out on the rebound or because selling is an admission of defeat, there's a strong psychological urge not to "lock in losses."

But this aversion makes no sense. It's not as if hanging onto the investment will somehow make it more likely to recover or that you get extra credit for loyalty. What matters is that you earn a decent return going forward.

I certainly don't want to encourage unnecessary buying and selling. In fact, I think it generally pays to keep trading to a minimum. But if you have a losing investment that qualifies for a tax write-off, by all means you should consider selling it and locking in the loss for the tax benefit (assuming, of course, that benefit is large enough to outweigh transaction costs).

You can then figure out how to reinvest the proceeds appropriately, whether than means buying back the same investment if that makes sense (while being mindful of the wash-sale rules) or, if not, investing in something new.

If you own a sagging investment that doesn't qualify for a tax loss -- whether because it's held in a 401(k) or IRA or because it still sells for more than you paid for it even though it's declined in value recently -- the decision to hold or sell should be based on whether the investment is still right for you.

If you like its prospects and it fits into your portfolio's overall mix, keep it. If you've concluded it's a dog or it doesn't mesh with your portfolio, jettison it.

But don't let a fear of locking in losses get in the way of that assessment.

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