Question: I recently received a small class-action settlement check from Lucent Technologies for inflated stock pricing. I owned the stock in my IRA, and the check is made out to me and Vanguard, my IRA custodian.
Do I cash the check or send it to Vanguard? — C.W., O'Fallon, Ill.
Answer: We called Vanguard about your situation, and the company agreed to accept the check and tuck the money back into your IRA. Endorse the check and send it to Vanguard, with instructions to roll it into your account.
"A settlement is not considered a contribution," says IRA expert Ed Slott of Rockville Centre, N.Y. "It is replacing lost value and constitutes a valid rollover to your IRA."
Slott says that you are on solid legal footing, because the IRS issued 11 private-letter rulings at the end of 2004 regarding legal settlements in connection with investments inside IRAs. Although such rulings apply only to the individual cases they address, they are an indication of how the IRS would rule in similar circumstances.
Question: In 1999 I rolled over $30,000 from a traditional IRA to a Roth IRA. The account is now worth only $11,000. I heard that I can close out the Roth, take the $11,000, penalty-free, and claim a $19,000 loss. Is that correct?
I have another Roth that has been profitable. Does that affect my ability to claim the loss? — K.K., New York, N.Y.
Answer: The profitable Roth does come into play. Only if you liquidate all your Roth accounts and wind up with less than your basis do you have a deductible loss. Your basis is the total after-tax money you've invested, including the $30,000 you rolled over, because you had to pay tax at the time of the conversion.
Let's say that you've contributed $10,000 to your second Roth and it's now worth $15,000. If you were to liquidate both accounts, you'd pull out $26,000. Comparing that to your basis — $30,000 plus $10,000 — would leave you with a $14,000 loss. It's deductible as a miscellaneous expense, not as a capital loss.
Miscellaneous write-offs are deductible only to the extent that they exceed 2 percent of your adjusted gross income. If closing both Roth accounts would give you a tax break today, you have to weigh your savings against the loss of tax-free earnings in the years ahead. Once the money comes out of the Roths, it can never go back in.