Tax Deductibility of Variable Annuity Losses

Question in an internet chat discussion…

Stephanie in Lawrence: Nobody wants to answer my question. I was devastated by a loss of $16,000 in my variable annuity last year. If I can claim the loss on my taxes, it will give me a few dollars back but, I don’t know if it’s worth pursing. My tax accountant said to ask my financial advisor (I did) and he said to ask my tax accountant (I did). I called the company which had the annuity – they said to ask my tax accountant or my financial Advisor. I’ve done research on the internet, but I am still confused.

Here is the general opinion on the topic from annuity leaders…. BUT always get your advice from your tax preparer…

Taking the Bite Out Of Annuity Losses

Are you stuck with an annuity that’s lost more than half of its original value? You’re probably not the only one. In the last two decades, the sales volume of variable annuities has seen phenomenal growth: skyrocketing from $4.6 billion in 1987 to $128.4 billion in 2004. Unfortunately, many investors who put large sums of money into annuities while the stock market climbed towards its peak in 1999 had no sense of the large losses they were about to face.

The Fall of Variable Annuities

While many investors enjoyed the double-digit returns of the late ’90s, many also suffered through the decline that followed in the ensuing three years. From 2000 through 2003, the S&P 500 lost an average 42%. An investor who purchased a $500,000 annuity in 2000, invested primarily in large U.S. companies, could have lost over $210,000 by the end of 2003. In fact, investors lost billions, and suddenly everyone was scared to death of the stock market. The sales techniques used by variable annuity salespeople were widely criticized and regulatory agencies grew concerned about annuity misrepresentation.

Knowledge of less-than-exemplary activities in the financial industry (lack of full disclosure and falsification of variable annuities) led to the rapid education of many investors, as they learned about surrender penalties, fees and expenses and the liquidity associated with variable annuities. Then, to add insult to injury, the IRS reduced the federal capital gains rate down from 28% to 20%, and down again to the current 15%, while maintaining the ordinary income taxation of annuity profits (when withdrawn). Armed with their newfound knowledge and tormented by the large losses in their annuities, many investors were eager to shift their money out of variable annuities, but steep surrender charges made replacement tough.

So, what options are available to investors?

Options for Your Underperforming Annuity

Surrender Your Annuity: Cash out of the annuity and use your funds for another type of investment. Make sure you call the annuity company first to verify if there are any surrender charges remaining on the contract.

Are Annuity Losses Deductible?

For a non-qualified annuity loss to be tax deductible, the loss must be realized by completely cashing out or surrendering the annuity. Exchanges using the 1035 tax provision will not qualify the loss for a tax deduction; however, the new contract can maintain the original cost basis. It’s important to remember that any surrender charges that apply will not be deductible as part of the realized loss.

Example

Let’s say that Matt purchased a non-qualified annuity three years ago for $50,000. Due to poor investment performance, his annuity is now worth $40,000 and has a surrender charge of $3,000. Despite the surrender charge, Matt decides to cash out his annuity and receives a check for $37,000. Even though Matt received a check for only $37,000, his actual realized loss on the annuity is only $10,000, since the surrender charge of $3,000 cannot be counted as part of the realized loss as per IRS standards. However, even if Matt is not 59.5 years old, he will not be subject to a 10% IRS early-withdrawal penalty because this penalty is only imposed on gains.

Now that we’ve determined that Matt incurred a $10,000 realized loss, where should it be reported? Accountants have recently adopted two approaches to the reporting of this realized loss: an aggressive (many accountants favor the aggressive approach) approach and a somewhat more conservative one. The conservative approach is to include the loss as a miscellaneous itemized deduction on Schedule A, where only the part of the loss that exceeds 2% of your adjusted gross income can be reported in this case (this may also subject you to the alternative minimum tax [AMT]). The more aggressive approach would have you take the position that the loss could be considered an ordinary loss sustained during the taxable year while entering into a transaction for a profit. In this case, the loss would be entered on Line 14 “Other gains & losses” (Form 1040) of a federal tax return), and the full loss could be deducted (without AMT issues).

Conclusion

The IRS Revenue Ruling 61-201 provides a minimal amount of authority for the idea that annuity losses would be acceptable as an ordinary loss (aggressive approach), but the safe gamble is to claim it as a miscellaneous itemized deduction. Regrettably, the IRS has not given any firm guidelines as to the proper way to claim the loss. Most financial planners will take the position that an annuity loss is an ordinary loss directly reportable on the front of your federal tax form. However, it’s usually best to let your tax accountant make the call, since this is undoubtedly a questionable area that could be challenged by the IRS.

In either case, there are potential benefits to surrendering an underperforming annuity. Just be sure to consult with the annuity company prior to taking any action so that you’ll understand the charges (if any) that are involved. As always, remember to maintain a long-term perspective with your investments – you don’t want to burden yourself with an investment change today if it is not going to add value to your finances in the future.