A down market or simply bad investments can lower your 401k dramatically. However, losses to your 401k are not covered by any tax credit. With certain circumstances though, you might be able to claim a deduction.
Your 401k usually has variable rate investments like stocks and mutual funds. As the market rises and falls, your balance will fluctuate up to 5% and sometimes more. These market movements are not deductible since you could write off any losses and keep the gains when they’re to be had.
You can only claim a loss in the year that you close your account. That amount is limited to your after-tax contributions minus any distributions you’ve made from the plan. Since most 401k plans are funded with pre-tax dollars, the majority of people will never get a 401k plan deduction. This makes sense since you’ve never paid taxes on that money. If you were to then be able to deduct that, it’s like you deducted that money twice.
So what if you have a Roth 401k? You make nondeductible contributions to this type of plan since they are funded with after-tax dollars. If your losses are bad enough, you may qualify for a deduction. For example, if you contributed $25,000 to the plan throughout the years and when you close it it’s only worth $15,000. You proceeds are $10,000 less than your nondeductible contributions. You then can claim the $10,000 loss.
To claim the deduction, you need to itemize using Schedule A. Further, it’s considered a miscellaneous deduction by the IRS and is subject to the 2% of the adjusted gross income threshold. Therefore, only the portion of your loss which exceeds 2% of your AGI is deductible.