401(k) & Wash Sales

[Wiles]

Loss of basis?

This surprised me, because it seems to result in complete loss of basis.

This is an interesting dilemma, especially for us accountants who believe the world operates on double entry accounting. Is it possible that one would now have basis in their IRA for the disallowed loss?

[JohnH]

This was where my question was going, but I haven't had time to get back to it and think it through. On the surface, it appears that the basis just disappears, because I don't see a mechanism for bringing the cost basis into the retirement plan.

[ATSMAN]

In a typical 401(k) plan the employee contributions are pre-tax so there is no basis to consider at the time of distribution, 100% of distributions (gains and contributed amounts) are taxable.

Some 401(k) plans allow some after tax contributions, that has basis equal to the sum of your after tax contributions.

Unless it is a solo 401(k), the plan participants really don't have direct control or dominion over the plan investments. The Trustee(s) do, and larger plans have investment committee that are delegated some powers, but the 401(k) trust retains ownership of the plan investments. Solo 401(k) plans are exempt from ERISA rules.

[JohnH]

Let's walk through this, and somebody correct me if I'm wrong.

1) I buy a stock for $50 in my regular investment account.
The price drops, so a couple of years later I sell it for $35 on Dec 20.
I have a $15 long-term capital loss.

2) Same scenario as above, but it goes back up to $38 and so on Jan 7 I decide to buy it back. I cannot deduct the $15 capital loss, and now my basis in the stock is $53. A couple of years later I sell it for $60, reporting a $7 long term gain. (All of this ignores transaction costs, although I'm sure my broker won't be ignoring them)

3) Same scenario as #2, except I bought it in my qualified plan on Jan 7. If the wash sale rules apply, I am unable to deduct the $15 LTCL, and although I own the same stock in my qualified plan, now it has no basis. So my entire basis disappears and I will be taxed at ordinary income rates whenever I take a withdrawal from my qualified plan.

Bottom line is I lose the tax benefit of the entire basis in the stock (not just the deferred loss on the wash sale). Plus I'm swapping capital gain for ordinary income. Looks like a lose-lose proposition all the way around. (EDIT: I made a mistake with part of this - I've corrected it in a subsequent post. Only the deferred loss on the wash sale is lost, but it is still true that it really has vanished)

Am I adding apples and oranges or double counting somewhere in this analysis?

[ATSMAN]

The way I explain it to clients is that the $50 that you just contributed to the 401(k) from your wages has a tax basis of 0 because you already realized the tax savings upfront by excluding it from your taxable income. So that $50 is now sitting in the trust account with a tax basis of 0. Any gains and losses that happen is basically a paper transaction from the participant's perspective. If that $50 comes out as $48 you have a taxable consequence of $48 (there is no $2 loss to deduct). If it comes out as $52 you have a taxable consequence for the full $52 ($50 is the amount on which you never paid any taxes when you earned it and stuck it in the 401(k) and $2 is the gain that you realized on that $50)

[JohnH]

You're right with respect to the "qualified money" aspect of any retirement plan. But in this instance, a transaction outside the qualified plan is being influenced by a transaction within the qualified plan, and the scenario changes considerably. There is a real economic loss of the tax benefits of the entire basis under these circumstances - it is not a "paper-only" transaction.

I did discover one big flaw in my scenario which needs to be changed. The ENTIRE basis is not lost, because the proceeds from the sale are now sitting in the investment account, either as cash or as an investment in another stock. But the long term capital loss is gone forever. It was excluded by the wash sale rules and not cannot be attached to another transaction as a basis increase.

Still, the problem remains because a transaction outside the qualified plan is being affected by something happening within the qualified plan. I can't think of another scenario where this occurs.

[buzzardbreath]

It's Me Again Margaret!

I believe we are short-sheeting ourselves if we believe a 401k has no basis. I do believe there are a number of scenarios where it can. First might be an excess contribution for which a tax has been paid. Another might be a reverse distribution as a result of a top-heavy declaration. There are many more scenarios where an IRA could have a basis, but we're not talking about an IRA, I suppose.

I'm not convinced that a wash sale rule applies, but if it does, the disallowed loss would be yet another scenario where basis could occur.

[ATSMAN]

Corrective distributions from a 401(k) are taxed just like ordinary distribution (without any pre mature distribution penalties) in the year the distribution is made.

So say in 2013 you contributed $5000 into your 401(k). That full $5000 was excluded from your taxable compensation. In 2014 you received $500 as a corrective distribution with a 1099R for 2014. You just add the $500 on line #7 (NOT line #16)

[buzzardbreath]

Software Doesn't Agree

ATSMAN, I don't have any reason to doubt you, or that the instructions call for the corrective distribution on Line 7.

I have had a number of these (1-2 every year) that are designated as such in the distribution code, yet the software (Drake) has put the money on line 16. Are they wrong?

[ATSMAN]

IRS Instructions say line #7

Not sure why the software takes a different position because the IRS instructions are posted below. It clearly says that corrective distributions go on line #7 and not line #16a and 16b. Have you brought this to Drake's attention?

The AGI is not impacted so I guess at the end the tax is calculated correctly?

May generate a CP2000 at some point?


Lines 16a and 16b
Pensions and Annuities
You should receive a Form 1099-R
showing the total amount of your pen-
sion and annuity payments before in-
come tax or other deductions were with-
held. This amount should be shown in
box 1 of Form 1099-R. Pension and an-
nuity payments include distributions
from 401(k), 403(b), and governmental
457(b) plans. Rollovers and lump-sum
distributions are explained later. Do not
include the following payments on lines
16a and 16b. Instead, report them on
line 7.
Disability pensions received before
you reach the minimum retirement age
set by your employer.
Corrective distributions (including
any earnings) of excess salary deferrals
or excess contributions to retirement
plans. The plan must advise you of the
year(s) the distributions are includible in income.