Can IRA Transactions Trigger the Wash-Sale Rule?
If you sell stock at a loss, you should be able to use the loss to offset gains on your income taxes, right? Right–except if you violate the wash-sale rule, which states that if you bought and sold the same investment for a loss within a 30-day period, then the loss cannot be used to offset gains.
However, you are allowed to add the loss to the cost of the securities that you repurchase, thereby increasing the basis. This issue becomes more complicated if you repurchased the securities in your IRA. Does that also increase the basis in your IRA? In 2008, the Internal Revenue Service addressed this long-unanswered question.
What Is a Wash Sale?
Let’s start by defining a wash sale, which occurs when you sell shares of a stock and repurchase or acquire the same stock within 30 days (before or after) of the sale. Wash sales create the illusion of a change in holdings. As such, the IRS enforces the rule to prevent investors from claiming a tax deduction on a loss on property that they still own.
Any loss from the wash sale cannot be used to offset gains on your taxes for the year. Let’s look at some examples:
Example: Wash Sale
You own 100 shares of XYZ with a basis of $2,000.You sell 100 shares of XYZ on March 21 for $1,000.You buy 100 shares of XYZ on March 22 for $600.
This is a wash sale and you cannot deduct the loss of $1,000. However, you can add the loss of $1,000 to the new purchase price of $600, creating a basis of $1,600.
Example: No Wash Sale
You own 100 shares of XYZ with a basis of $2,000.You sell 100 shares of XYZ on March 21 for $1,000.You buy 100 shares of XYZ on June 2 at the market price.
This is not a wash sale because the purchase did not occur within 30 days of the sale.
A wash sale can occur with other securities, such as bonds, mutual funds, and options. For example, options are considered substantially identical to the stock they reflect, so selling options on a stock you own could trigger a wash sale. Because a mutual fund exchange is technically a sell and a buy, if you exchanged into the same fund you previously sold within 30 days, that’s also a wash sale.
Does the Rule Apply to IRAs?
In 2008, the IRS issued “Revenue Ruling 2008-5,” in which it addressed the question of whether the wash-sale rules apply to IRAs. In the ruling, the IRS explained that when shares are sold in a non-retirement account and substantially identical shares are purchased in an IRA within 30 days, the investor cannot claim tax losses for the sale, and the basis in the individual’s IRA is not increased.
Example: Claiming Tax Losses in an IRA
Suppose that you own 100 shares of YYY stock with a basis of $1,000 in your brokerage account. You sell the 100 shares of YYY at a loss, for $400 on Oct. 10. On Nov. 1, you buy 100 shares of YYY stock in your IRA account for $800.
According to “Revenue Ruling 2008-5,” you cannot deduct the $600 loss on the sale, and you cannot increase the basis of the stock purchased in your IRA by the $200 difference between the sell and repurchase.
IRS “Revenue Ruling 2008-5” prevents investors from using the cloak of a tax-deferred account type such as an IRA to circumvent the wash-sale rule. It applies to traditional and Roth IRAs, regardless of whether the IRAs are held at different financial institutions.
What If You Break the Rule?
You may have executed the wash sale to decrease your current taxes, but by breaking the rule, you’ve only deferred the taxes and you may have to pay the early distribution penalty on the amount.
For example, let’s say you’re ready to take a distribution from your traditional IRA. You sell stocks previously purchased in a wash sale and withdraw the proceeds. Normally, the portion of the distribution considered part of your basis is not taxable. Since your purchase in the wash sale did not increase your basis, the total value of the proceeds from those shares is taxable when distributed from your IRA.
The same rule applies to non-qualified distributions from a Roth IRA in that the wash sale does not increase the basis in the Roth IRA.
Example: IRA Wash Sale
Suppose that you own 100 shares of stock with a basis of $3,000. You sell the shares for $1,500, for a loss of $1,500. Within 30 days, you purchase 100 shares of the same stock for $1,000 (a wash sale) in your traditional IRA (basis = $0). You sell those 100 shares for $2,000 and withdraw the proceeds (taxable amount = $2,000.) If you had sold the shares for $800, the taxable amount would be $800.
How to Avoid Violating the Rule
You can ensure that you do not violate the wash-sale rule by following some simple guidelines:
View all investments as a single portfolio, regardless of the account type. Plan tax-related transactions based on your entire portfolio. This will help you recognize when a wash sale might occur.
Sell stock at a loss more than 30 days before or after purchase to claim tax benefits. To maintain your asset allocation strategy, buy a different stock in the same category (for example, a different utility stock). You want to make sure that the stocks cannot be categorized as “substantially identical.”
Use a set investment plan or method. Having performance goals for each investment and a contingency strategy keeps you focused on making well-conceived investment decisions as opposed to arbitrary trades.
Invest in volatile investments outside of IRAs and other tax-deferred accounts. This will allow you to take advantage of tax benefits by changes in taxable gains and losses. Buy investments that pay dividends and interest inside an IRA. You will be able to maximize the tax deferral of income and reinvest it in your retirement fund.
Use automatic dollar-cost averaging or automatic liquidations for withdrawals from your IRA. Don’t purchase these same investments in other accounts.
Don’t implement options strategies based on stocks.
Use stock matching on a first-in, first-out basis to determine whether you are in danger of violating the wash-sale rule.
If you own a stock that took a big dip and you can’t stand the fall, sell it. If it’s a dog, there’s no need to buy it back, no matter how low the price.
The Bottom Line
The wash-sale rule applies to all investment accounts you own or control, including your spouse’s account. Be sure to keep the lines of communication open between you and your spouse about trades in your portfolios for this exact reason.
When in doubt, consult with a competent tax professional to ensure that the proper and most effective tax strategies are applied to your investments.