Are 401k Losses Tax Deductible?

If you lose money on your 401k investments, you may be able to deduct the losses against your taxes. This is a great way to save on your income tax bill.

You can deduct up to $3000 in investment losses per year, total. You can also carry forward these losses.

Employer Contributions

When you work for a company, payroll deductions are withheld from your paycheck to pay for things like 401k, health insurance, union dues and social security taxes. In some cases, these are voluntary, while others are mandatory.

Employee contributions are matched by the employer on an equal basis. Federal Insurance Contributions Act (FICA) taxes are paid by both the employer and employees, with 6.2% of gross wages going to Social Security and 1.45% to Medicare.

Employer-paid disability insurance premiums, health and life insurance, 401k plan contributions, profit share and other benefits are also tax deductible. However, these are not deductible for the employer’s spouse and dependents.

Employers should make sure that they have accurate payroll records and are reporting taxable wages and substantiated expenses to the IRS. If there are unsubstantiated amounts, they should be returned within 120 days. Additionally, employers should be aware of their responsibilities to report nondiscrimination testing results. If compensation doesn’t meet 414(s) requirements, then contribution allocations must be tested for nondiscrimination using compensation definitions that do.

Non-Employee Contributions

A 401k plan allows employees to defer part of their wages on a tax-deferred basis with the aim of accumulating assets for retirement. Employees also have the option of receiving distributions (usually before age 59 1/2) due to termination of employment, disability or death.

There are a number of non-employee contributions that are tax deductible on an employee’s 401k account. These include profit sharing, nonelective and matching contributions.

These contributions are a common feature of most employer-sponsored plans, especially defined contribution plans such as 401ks. They must be allocated to participants’ accounts using the correct compensation definitions.

However, one of the most common mistakes that employers make is allocating the wrong compensation to participant accounts. This can result in a plan failing the IRS test that would have passed using the correct compensation.

True-Up Contributions

The amount of any 401k losses that a taxpayer has can be deducted from his or her taxable income. This deduction is available for all IRAs of the same type, and it applies to both active and passive losses.

The IRS allows a self-employed person to contribute up to 25 percent of their earned income to a self-directed 401k plan, as long as they don’t have employees and the owner’s spouse doesn’t work for the business. This can significantly reduce current taxable income.

Those who are over 50 can also make catch-up contributions of $5,500. These can be used to further reduce taxable income.

Contributions are deductible on an employee’s tax return and count as wages for Social Security and Medicare. The pretax contribution is included in federal wages (box 1) and state and local wages (boxes 16 and 18).

Passive Losses

Passive losses are any losses resulting from investments in trades, businesses or income-producing activities that the investor doesn’t “materially participate” in. These can include business partnerships, S corporations, limited liability companies and sole proprietorships that the investor doesn’t own or operate.

However, passive losses are not deductible against earned income or other nonpassive income items like interest, dividends, annuities, royalties and gains or losses from most property dispositions.

The PAL Rules were introduced in 1986 to curb tax abuses from people using real estate and businesses to generate losses that could then be used to offset taxes owed on nonpassive income.

When a taxpayer disposes of an S corporation interest in a fully taxable transaction to an unrelated party, the shareholder is allowed a deduction for suspended passive activity losses. These carryover losses can be used to offset passive income in future years.