It May be a Down Market, But Don’t Compound Your Losses!

76531025It happened again today. One of my clients said, “We have lost so much in our mutual funds that I should just sell EVERYTHING and start over.”  I asked him, “How do you know that you have a taxable loss?”  He looked at me and replied, “Everybody knows that the whole market is down by at least 40%! That’s how I know.”

Many seniors are panicking and making big mistakes in dealing with investment losses.  The two main errors made are:

  • Thinking that perceived investment losses are the same as tax losses; and
  • Failing to understand that any withdrawal from an IRA, 401(k), or 403(b) will always be treated as ordinary income. 

In today’s blog we’ll tell you how to avoid falling into these two traps.

The loss our client feels is what I call the “the quarterly statement loss,” but it is not usually the same as a taxable loss. If you ignore Mr. Taxman’s rules, you could wind up compounding your losses.  The way to compute a taxable loss is to look up what you originally paid for an asset and compare that purchase price to the current sale price.  Let’s say that your rental property would sell today for $200,000, but in 2007, it would have sold for $300,000. What kind of a loss have you suffered?  Does the tax-man think that you have a loss?  The answer is, no!

If you bought your investment real estate at $300,000 in 2007, and in 2009 you sell at $200,000, then Mr. Taxman will agree that you have a long-term capital loss of $100,000 (please assume that we are ignoring depreciation and other adjustments).

But, if you are like most of my senior clients, you may have purchased the asset a long time ago at a price that is lower than today’s sale price.  If you sell today, you may have a significant tax bill, even though you feel like you have ‘suffered’ a loss of value.

For example, if you bought the rental property in 1975 for $50,000, the actual gain or loss will be computed from the original sales price (less any depreciation that you took as a deduction on an annual basis) compared to the current sales price.  So, if you sell that property now, you will be looking at a significant taxable gain. 
The tax loss magnification is even greater when someone tries to cash out their perceived losses in an IRA.  My friend Rudy Beck, a St. Charles, Missouri elder law attorney, recently shared a horrifying story of how a 58-year-old client created a taxpayer’s nightmare because she cashed out her IRA due to her perceived losses.  The client’s “very knowledgeable” daughter had advised her to sell 100% of her IRA investments.  She liquidated $150,000 of mutual fund investments with the expectation that she had a “$55,000 loss.”  Attorney Beck had to tell her that she had created 2008 taxable ordinary income of $150,000 AND a 10% early withdrawal penalty of $15,000.  It’s critical that you remember that money in your IRA represents deferred wages.  No matter when or how the money comes out of your IRA, it will be treated as if you are now receiving those wages.  You pay the income tax rate to the federal and state government.  The government never allows you to treat IRA withdrawals as a tax loss.

The majority of people have better things to do in life than study either investments or taxes, so please seek the advice of tax professionals before you assume that your “investment losses” are also “tax losses.”

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My wife and I had our first child three years ago. That’s when we decided to set up a trust, should anything happen to either of us. We reached out to Zach Hesselbaum to help us out. He was very thorough and professional throughout the whole process. Zach went above and beyond to make sure that we understood every detail of setting it up and he did an excellent job. We recently had our second child a few months ago. With the new baby, he helped us make the necessary revisions to the trust. Zach made this process great for us! I would definitely recommend using him for any of your estate planning needs!

Tom G., Naperville, IL