Last week’s post answered the question, “What is the right mix of retirement vs. nonretirement investments in a retirement income plan?” with a simple, but correct, answer: “It depends.” It pointed out that each scenario is different, requiring a professional analysis by a qualified retirement income planner of the interaction between a host of many variables unique to that situation.
One of the variables mentioned last week was income tax carryover losses. There are limitations on the amount of losses arising from various types of transactions that may be deducted on the tax return for the year in which the loss incurred. The portion of the loss that isn’t deductible in the year of origin of the loss must instead be carried forward to the following year, and potentially to additional future years, until the requisite type and amount of income becomes available to absorb the loss.
An example of a common income tax carryover loss is a capital loss. After netting capital losses against capital gains, to the extent that there is an excess of capital losses over capital gains, you end up with a net capital loss. Under income tax laws that have been in existence since at least 1980 when I started practicing as an accountant, only net capital losses up to $3,000 ($1,500 if married and filing a separate return) are allowed to be deducted in the current tax year. Any net losses in excess of the specified amounts are required be carried forward to the following year.
If you have a sizeable capital loss carryover, as many people do as a result of 2009 securities sales when the stock market plummeted, nondeductible contributions to a nonretirement investment account may be preferable to making deductible retirement plan contributions, including 401(k) plans, SEP-IRA plans, deductible IRA’s, and other retirement plans. This assumes that you’re not planning on selling an asset, such as a piece of real estate or a business that will generate a sizeable capital gain that can be used to absorb your capital loss carryover.
Why is this? Doesn’t it make sense to contribute to a retirement plan where you know that you’re going to receive a current income tax deduction, often sizeable, that will save you a bunch of income taxes today? Keeping in mind that the tradeoff for a current income tax deduction when it comes to retirement plan contributions is deferred income inclusion and associated taxation when the assets are distributed, perhaps at a higher tax rate, the answer to this question isn’t necessarily “yes.”
This is especially true when large capital loss carryovers are present. If you’re in this situation and you don’t realize any capital gains, you will be taking a $3,000 tax deduction on your tax return for many, many years with the possibility, depending upon your age and the amount of your loss, that your carryover loss won’t be used in its entirety during your lifetime. Given this situation, the goal should be to create opportunities for capital gains that can be used to absorb chunks of your capital loss carryover each year without incurring any income tax liability until such time as there is no further available capital loss.
How do you do this assuming limited financial resources? One option that can make sense in many situations is to divert funds that would otherwise be used for making deductible retirement plan contributions into nonretirement equity investment accounts that have the potential to generate capital gains. To the extent that the equities appreciate in value, they can be sold, with the gains generated by the sales used to offset a portion of your capital loss carryover without incurring any income tax liability. Furthermore, unlike other situations where capital losses aren’t present and your goal may be to hold onto investments for longer than a year in order to obtain the benefit of favorable long-term capital gains tax treatment, this isn’t necessary. Capital loss carry forwards can be offset again any capital gains, whether short- (i.e., one year or less) or long- (i.e., greater than one year) term.
Using this strategy, you won’t receive an income tax deduction for investing in your nonretirement investment account. You will, however, create an opportunity to potentially increase the value of your nonretirement account up to the amount of your capital loss carryover plus $3,000 without incurring any income tax liability that you might not otherwise do. In addition, once your capital loss carryover has been used in its entirety, subsequent sales of assets can create additional losses or capital gains that can be taxed at favorable long-term capital gains rates. All of this can occur without exposing yourself to guaranteed ordinary income taxation at potentially higher tax rates down the road when you take distributions from your retirement plans had you instead invested the same funds in retirement plans.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.