The government provides a tax deduction for losses in 401k plans. However, you need to know the rules and how to claim them.
The first rule is to avoid buying a substantially identical investment within 30 days of selling your losing one. That is known as the wash sale rule.
Loss deductions are subject to a 2 percent of adjusted gross income (AGI) limit
Adjusted gross income, or AGI, is the difference between your gross income (income from wages, tips, dividends, interest, pension distributions, and other sources) and certain deductions. This is an important number to know since it can determine your eligibility for certain tax credits and deductions.
AGI can also help you determine whether you’re eligible for retirement savings contributions and health insurance subsidies. It is also used to calculate taxable income when you file your taxes.
Generally, you can deduct the premiums for your own health insurance from your taxable income as long as they are reported on your W-2 as a pre-tax benefit. However, you may not deduct them if you are self-employed or a partner with net self-employment income or an S corporation with more than 2% ownership in that business.
You can deduct up to 30% of your non-cash charitable donations and 60% of your cash gifts. These limits may be reduced for donors with high AGI.
They are itemized deductions
The Internal Revenue Service (IRS) has strict guidelines about claiming losses on 401ks and IRAs. If you’re not careful, your retirement savings can be destroyed by a stock market crash.
However, the good news is that 401k losses can be tax deductible, as long as you close your accounts and have total distributions that are less than your original investment basis. The amount of the deduction equals your after-tax contributions to the account minus all distributions you’ve taken out, including the contribution used to close the account.
If you have a loss, deduct it as an itemized deduction on Schedule A and subtract 2 percent of your adjusted gross income. This will reduce your taxable income, but it also limits the amount of other deductions you can claim. For example, medical expenses are limited to 7.5 percent of AGI, and many other credits are restricted by AGI.
They are subject to an early withdrawal penalty
If you withdraw 401k losses before 59 1/2, you’ll typically be subject to an early withdrawal penalty. This penalty is imposed by the Internal Revenue Service (IRS), and it’s designed to encourage long-term participation in employer-sponsored retirement savings plans.
The penalty is assessed in addition to any income tax you owe on the money you withdraw, which can make it difficult for savers to decide whether it’s worth taking out 401k losses early.
Another option is to take advantage of exceptions that allow you to withdraw from your 401k without incurring a penalty. This is particularly helpful if you’re losing your job or have a life event that will require you to withdraw your 401k.
Starting in 2024, the IRS will also exempt taxpayers from paying a penalty for using their retirement funds to pay for certain emergency expenses. These can include costs related to domestic abuse or natural disasters.
They are not available for Roth 401(k)s
A Roth 401(k) is a retirement plan that allows you to make contributions after taxes are deducted from your paycheck. This treatment contrasts with a traditional 401(k) where you make pre-tax contributions, which lower your taxable income now and reduce the amount of taxes you owe in retirement.
If you have a Roth 401(k) and decide to withdraw your earnings, you must meet certain requirements. These include a five-year holding period and being 59 1/2 years old.
Those under age 59 1/2 are subject to an additional 10% early distribution tax when they take a withdrawal. But if you’re older than 59 1/2, your withdrawal is completely tax-free.
Ultimately, the decision to contribute to a Roth 401(k) or a traditional 401(k) depends on your future income and tax rates. However, if you think your tax bracket will be higher in retirement, a Roth 401(k) can be a better choice. This is because a Roth contribution will postpone the tax obligation until you retire, when you can withdraw the money tax-free.