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Tax Guru-Ker$tetter Letter
Friday, July 19, 2002
Gambling With Retirement Dollars

With so many people taking it in the shorts with the decline in the stock market, I just wanted to cover a few of the most common questions that come out in times like this. For those of you who are relatively new to stock investing and are experiencing your first big market downturn, welcome to the real world. These cycles of up & down have happened since the beginning of time and if you were under the impression that the stock market was a guaranteed no-lose proposition, consider this to be your lesson in Investing 101. In spite of what our former president & his worshippers claimed, he did not permanently erase business & market cycles.

Retirement Accounts
Whenever market values decline, people want to know how they can deduct the losses for their retirement accounts decreasing in value. I have to break the news that no such immediate tax deduction is allowed. I have never been shy about pointing out unfair aspects of the tax laws; but this one is perfectly legitimate, which I will explain.

Deductible losses are based on the amount of your cost basis in the asset. Pre-tax retirement accounts, such as IRAs and 401Ks have a cost basis of zero for income tax purposes. They are designed to produce taxable income when the funds are withdrawn, normally during your retirement years. If these accounts are heavily invested in risky stocks, you will actually receive a kind of tax deduction later on because there will be less money to withdraw and pay taxes on. This is why I have always advised conservative investments with retirement accounts.

A related subject is the taxation of capital gains in retirement accounts. All withdrawals from retirement accounts are subject to ordinary income tax rates, even if the funds were from long term gains. This is a big difference from investments made with after-tax dollars. In those cases, long term gains (assets held over 12 months) are subject to lower income tax rates. You should keep that in mind when deciding whether an investment should be made with a pre-tax retirement account or with your own money.

Capital Loss Limits
Here is a very big and very unfair double standard in the tax code. If you have an overall net capital gain for a year, it is all added to your other kinds of income and subject to income tax, with no dollar limit. On the other hand, if your capital losses exceed your capital gains for the year, the most you are allowed to deduct on the current year's 1040 is $3,000 per person or per couple (marriage penalty). The unused losses are carried over to your next year's Schedule D, where you can use them to offset gains earned during that year. Again, only a maximum net loss of $3,000 can be used to offset other kinds of income per year.

Suppose, you have a net capital loss of $300,000, which I have seen on some actual tax returns. How long will it take to use up all of the extra $297,000 of excess losses? While they can technically be carried forward indefinitely, that really isn't the case. What if the person passes away before s/he has utilized all of his/her capital losses? Can those unused losses be passed on to his/her heirs? Nope.

If you agree that this is adding insult to injury to investors, I can only encourage you to contact your elected rulers in DC and tell them how you feel.


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