• Closing 401K & Taxes

Are 401(k) Losses Tax-Deductible When Closing a 401(k) account?

by Noel Bagwell
for Executive Legal Professionals, PLLC

March 18, 2015

Are 401(k) Losses Tax-Deductible? What about tax-creditable?

First, I should note I am not a tax attorney. I have no specialization or special expertise in tax law. As of the time of this writing, I do not have an LL.M. in tax law. Alright, with disclaimers out of the way, let’s move on to the topic of the day.

The question today’s article answers is:

“If one will be closing his or her 401k, and they will be taking a loss on their mutual fund and stock purchases, can this loss be taken directly off of the top of what they will owe the IRS, or can this loss only be used to adjust down their gross income?” 

At the heart of the question is the essential difference between a “tax credit” and a “tax deduction.”

“Tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).

On the other hand, tax credits provide a dollar-for dollar reduction of your income tax liability. For instance, a $1,000 tax credit actually saves you $1,000 in taxes.” (Tax deductions)

“Tax credits can help reduce your liability dollar-for-dollar. However, they cannot reduce your income tax liability to less than zero. In other words, your gross income tax liability is the amount you are responsible for paying before any credits are applied.” (Tax credits vs. tax deductions)

Losses in 401(k)s usually aren’t tax-deductible, nor is there any credit for losses in 401(k)s. (Losses in 401(k)s Usually Aren’t Tax-Deductible)

In September, 2014, “the Internal Revenue Service issued a ruling that allows big savers to use their 401(k) accounts to fund Roth IRAs—without paying income taxes in the process.” (Good News and Bad for Retirement Savers) If you find yourself in this situation, you should ask your financial planner whether this might be a good move for you. “With pretax contributions to a traditional 401(k), … employees deduct their contributions and pay income tax on their withdrawals in retirement—when they may be in a lower tax bracket. With a Roth, employees forego an upfront tax deduction but their withdrawals can be tax-free. But with after-tax contributions, account owners receive no deductions and must pay income tax on the profits they earn.”

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In other words, “contributions to a traditional 401(k) plan are tax deductible. The money you put into a Roth 401(k) is not. But when you retire, none of your Roth 401(k) withdrawals are taxed, including all of the money you’ll earn from capital gains (the increased value of your mutual fund holdings), interest and dividends. While taking a tax deduction now may seem like the better choice, most families don’t save that much by deducting 401(k) contributions.”

I suggest using a certified financial planner to help you navigate your retirement investments and to help you better understand your tax liabilities with respect to said investments.


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