Congress created Individual Retirement Accounts (IRA) to encourage people to save for their later years. The encouragement takes the form of tax benefits. One important benefit is that the Internal Revenue Service won’t tax the money you earn inside an IRA until you begin retirement withdrawals, if at all. The downside of this benefit is that you don’t get to deduct losses on investments held in an IRA.
With a traditional IRA, you may claim a tax deduction for a portion of your investment, but you will pay taxes on the money you are allowed to begin withdrawing at age 59 1/2. The IRS treats the money you drain from a traditional IRA as ordinary income and taxes it at your marginal rate -- the tax you pay on the “last dollar” of annual income. A Roth IRA doesn’t reward you with a tax deduction, but you can remove your money tax-free, if you follow the rules. You must begin withdrawing money from a traditional IRA at age 70 1/2. Roth IRAs have no such requirement.
Your IRA custodian may limit the types of investments you can make. For example, if you open an IRA at a savings bank, you might be unable to purchase stock. You have many more choices by opening a self-directed IRA at a brokerage or other financial institution. You can then buy stocks, bonds, options and many other investments. You can also open an IRA that allows you to buy precious metals or real estate. Your interest, dividends and capital gains grow tax-free while the money remains in an IRA.
Losses on IRA Investments
While its true that you don’t pay tax on your earnings while the money resides in your IRA, the other side of this coin is that you don’t get to deduct losses on investments in your IRA. The effect of IRA losses is to reduce the value of your IRA and thus the amount available to withdraw. If you have a traditional IRA, losses reduce the taxes you have to pay on withdrawals, because you have less to withdraw. In a Roth IRA, you don’t pay taxes on withdrawals.
A wash sale occurs when you sell stock for a loss and then repurchase it within 30 days. Normally, you use your losses to reduce your capital gains, but you cannot take this deduction on a wash sale. Instead, the IRS has you add the disallowed loss to the cost of the replacement shares. This has the effect of postponing the tax deduction for the original loss until you sell the replacement shares, because the higher cost of the replacement shares reduces your profit or widens your loss when you unload them. IRAs appear if you sell shares from a regular brokerage account for a loss and repurchase them in an IRA within 30 days. It’s still a wash sale, but now you’ll never benefit from the loss, because it’s buried inside an IRA, where you can never deduct losses.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.