Close Close

Financial Planning > Tax Planning > Tax Loss Harvesting

When Exchanging, Surrendering Or Selling A Variable Annuity May Be Called For

Your article was successfully shared with the contacts you provided.

When Exchanging, Surrendering Or Selling A Variable Annuity May Be Called For

Judith A. Hasenauer

We are not sure who first made the statement that getting old is not for sissies, but truer words were never spoken. If gravity does not get your body, the confusion about how to provide for retirement security can surely get your mind.

Unfortunately, the only alternative to getting old is not one that we particularly care to contemplate. Even those who have done the right thing and attempted to protect their “golden years” by purchasing a variable annuity may find themselves in a quandary caused by the effect of market fluctuations on the value of their contracts.

Thus, even when taking the recommended course of action, people may still have the need for additional retirement planning and for consideration about whether they still have the right products to meet their retirement needs.

Most modern VAs contain valuable death benefit features that protect against loss to contract value if premature death of the owner occurs when market fluctuations have decreased the contract value below the purchase price. We think of such annuities as being “under water.”

Many newer VAs may even contain protections against market fluctuations for annuity payments or for making withdrawals. However, owners of the older contracts may not be able to take advantage of some of these newer enhanced contract features unless they somehow terminate the old annuity and obtain a new one with the new features.

So-called “1035 exchanges” are very common in the VA business. In effect, Section 1035 of the Internal Revenue Code permits the owner of an annuity to exchange it for another annuity without any recognition of gain for federal tax purposes. The advantages of such an exchange for a VA where the contract value exceeds the purchase price for the contract is obvious. It permits the contract owner to exchange an annuity for one that may have better contract features, or that may have better underlying investments, or that may have been issued by a stronger insurer, without having to worry about adverse tax consequences.

Regardless of the contract owner?s motivation for making such an exchange, the ability to conclude the exchange without adverse tax consequences is a valuable retirement planning tool. Properly done, a tax-free exchange can help the contract owner ensure that the policy is always the most current product available.

Needless to say, care should be taken to consider surrender charges, new sales charges and other factors that will impact the usefulness and the cost of the exchange.

If 1035 tax-free exchanges are useful when VA contract values are in excess of the purchase price, what about when contracts are under water? This is a good example that “one size does not necessarily fit all.” A contract owner of an ?under water? VA might well want to consider surrendering or selling the annuity rather than making an exchange.

Here is why: It is well established that the surrender of an annuity where the contract value is less than the purchase price can result in a deduction of the amount of the loss on the contract owner?s federal income tax return. An exchange of an ?under water? VA causes the contract owner to keep the same basis in the new contract as was in the old one. There is no tax deduction that results from an exchange. On the other hand, a surrender or sale of such an annuity “locks in” the tax loss and can enable the contract owner to buy a new annuity, with the features she desires, for a lower cost after having secured a valuable tax write-off.

It should be noted that although there does not seem to be any precedent that we have found that says the sale of an ?under water? annuity gives rise to a tax loss, there does not seem to be any logic for a contrary conclusion. After all, the surrender of an annuity is, in fact, merely a sale of the contract back to the insurer that issued it.

VA owners also should be advised that they may want to defer the purchase of a new annuity for a sufficient time to avoid having the transaction treated as a “wash sale” that would void the ability to take the tax deduction.

We are aware that a number of firms have begun buying ?under water? VAs. These firms are interested in maintaining the contract in force in order to obtain the guaranteed minimum death benefits than many VAs contain. In effect, if these firms hold the VAs until the death of the contract owner or the annuitant, they will receive more than they paid for the contract.

Generally, these firms that buy such VAs pay a premium over the amount the contract owner could get with a surrender or an exchange. Therefore, a contract owner may be better off financially by selling her contract instead of surrendering or exchanging it.

Obviously, contract owners should take the value of the guaranteed minimum death benefit into consideration before they exchange, surrender or sell their VAs. This is particularly true if the existing contract has a guaranteed minimum death benefit that has increased over the original purchase price of the contract.

In this context, the insurance agents and brokers who advise clients with respect to the exchange, surrender or sale of ?under water? VAs should be sure to take into consideration the tax consequences of the transaction.

Locking in tax losses may be a valuable addition to a contract owner?s ability to plan for retirement.

For some contract owners, the tax deduction may be worth as much as 35% of the amount of the loss. (Note: It is likely that losses on annuity contracts are subject to the 2% floor applicable to “miscellaneous other deductions.” Therefore, the deduction would not equal the complete amount of the loss.)

Failure by an insurance agent or broker to consider and advise customers regarding tax losses in an exchange transaction may well cause the entire transaction to be suspect as being suitable for the contract owner. Certainly, the casual exchange of an ?under water? VA may not be in the best interests of the contract owner.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU are attorneys in the Pompano Beach office of Blazzard, Grodd & Hasenauer, P.C. Their e-mail address is: [email protected].

Reproduced from National Underwriter Life & Health/Financial Services Edition, September 3, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


© 2023 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.