When you lose money on your normal investments, you get to claim a deduction in the year you sell the stock. However, just because your 401(k) plan balance went down doesn't mean you'll get a tax break. Only in rare instances will you be able to write off a 401(k) loss, and even then your deduction will be further limited by your adjusted gross income.
Just having a bad year isn't sufficient to get you a tax deduction for your 401(k) plan. A loss deduction is only available for the year in which you close your 401(k) plan, and your total distributions must be less than your basis. For example, if your basis for the 401(k) plan is $40,000 and you cash out $33,000, you have a $7,000 loss. You will be able to take a deduction only if your withdrawal consists of nothing but cash and worthless securities. If you receive securities that aren't worthless, you can't claim a loss. Alternatively, if you received $30,000 of cash and $3,000 of securities, you wouldn't be eligible to claim a loss.
Understanding 401(k) Basis
Your basis, which is used to figure your gain or loss, is the amount of after-tax contributions made to the account. Basically, if you don't pay taxes on the money before it goes into the 401(k) plan, the Internal Revenue Service isn't going to let you claim a loss for the same money a second time if the investments go down. With a traditional 401(k), you'll almost never have a basis because both your contributions made by taking money out of your paycheck and the employer's matching contributions are made with pretax dollars. With a Roth 401(k) -- the contributions to which are made with after-tax dollars -- you'll have a basis, so you might be able to claim a loss.
Miscellaneous Deduction Limits
As if claiming the deduction weren't hard enough, the IRS classifies the 401(k) loss deduction as a miscellaneous deduction subject to a threshold of 2 percent of adjusted gross income. This means only the portion of the loss that exceeds 2 percent of your adjusted gross income actually decreases your taxable income. As a result, the year you take the deduction matters. For example, if you have a $7,000 loss in a year that your income is only $50,000, your effective deduction would be $6,000. However, if you take that same $7,000 loss when your adjusted gross income is $200,000, you would only effectively deduct $3,000.
To make matters worse, the 401(k) loss deduction is an itemized deduction, which means you can only write it off if you give up your standard deduction. On Schedule A, the form used to report itemized deductions, report the deduction as a miscellaneous deduction on line 23. Then, after subtracting 2 percent of your adjusted gross income, the deductible amount goes on line 27.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."