Elderly With VAs Face Many Decisions

Regulatorsincluding the National Association of Securities Dealers, the Securities and Exchange Commission, and several state insurance departmentshave been raising questions about the suitability of selling deferred variable annuities to the elderly or making tax-free exchanges of such products for elderly contract owners.

The concern stems from the belief that elderly consumers have too short a time horizon before death or retirement for the tax savings inherent in a deferred VA to overcome the costs that are also inherent in the product. There also has been much concern about the increasing number of tax-free exchanges of variable annuities among elderly VA owners.

Despite these concerns, little guidance has been given about what existing owners of such VAs need to know in order to make an intelligent decision about whether to keep, surrender, sell or exchange their contracts.

And unfortunately, some regulators have started promoting a “one size fits all” approach to the question of what, if anything, a deferred VA owner should do with the contract.

We do not believe the same solution is appropriate for everyone who owns a deferred VA.

When thinking about whether to keep, surrender, sell or exchange the VA, the policy owner must base the decision on multiple factors that vary from individual to individual. These factors include family longevity history, availability of other resources, liquidity needs, value of the contract in comparison to the tax basis for the contract, and length of time to retirement and family obligations.

Another important factor: How the VA contract features compare to some of the more modern, enhanced benefits now available. Also, elderly VA owners might well consider annuitizing the contract to ensure retirement income they cannot outlive. Many insurers offer many enhancements for annuitizationenhancements not contained in the original contract.

It is surely obvious that federal and state income tax considerations are basic to ownership questions involving deferred variable annuities. Tax reduction was probably an important element in the decision to purchase the deferred VA in the first place. Taking into consideration the long-term tax ramifications of the transaction, tax reduction should remain fundamental to the decision of whether to keep, surrender, sell or exchange a deferred VA.

We have written previously about the choice between surrendering or selling a VA where the current contract value is below the contracts tax basis. As noted, the surrender or sale of such an “underwater” VA could have beneficial outcomes resulting from the potential to deduct the amount of loss on the contract on the federal income tax return. Although many commentators were then of the opinion that a surrender of such an underwater VA would give rise to a deduction for federal income tax purposes, there was no established authority for this. Fortunately, the Internal Revenue Service now has provided such authority.

In IRS Publication 575 (which provides information to taxpayers for preparation of their 2004 federal income tax returns), the IRS states (on page 19) that a taxpayer can claim a loss on the federal income tax return upon receipt of a lump-sum distribution that is less than the contract owners cost basis in the contract. Publication 575 says such loss should be taken as a “miscellaneous deduction” subject to the 2% of adjusted gross income limit applicable to such deductions.

The information in Publication 575 does not appear to differentiate between the surrender of an underwater VA to the issuing insurer and the sale of such a VA to a third party not affiliated with the issuing insurer. However, we are aware that at least one highly respected tax law firm believes there should be a difference in treatment of a surrender and a sale, with the sale resulting in a straight deduction against ordinary income in arriving at adjusted gross income, rather than a requirement to take the deduction as a miscellaneous deduction on Schedule A of the Form 1040.

There is no precedent for the IRSs position that the treatment of the loss on a VA must be taken as a “miscellaneous deduction” as opposed to taking it as a simple investment loss.

Moreover, we are not convinced that the position of the IRS is correct, particularly since the consequences of agreeing with such a position can be substantial. Not only is a loss that is treated as a “miscellaneous deduction” subject to the 2% of adjusted gross income limit, but a large loss could help to trigger the applicability of the Alternative Minimum Tax.

All of this complicates the decision of whether to keep, surrender, sell or exchange a deferred VA that is underwater. Such a decision requires careful consideration of all surrounding elements. If the VA contains features important to the contract owner at the owners current age and financial situation, it is likely that a surrender, sale or exchange is not a wise alternative.

On the other hand, there are newer contracts available today with valuable guaranteesfeatures that may have great importance to a VA owners financial well-being. Then an exchange may be warranted.

Before implementing an exchange, the owner should weigh the costs involved in the form of new fees and surrender charges that may start over again. In some instances, where a VA is underwater, the owner may be better off surrendering or selling the contract, taking advantage of the tax deduction, and then seeking to place the proceeds into another investment that contains the desired features. This enables the owner to “lock-in” the tax deduction while keeping the same cash value in a new form of investment that may be better suited for the needs.

It is not clear whether a surrender or sale of a deferred VA that is underwater, where the proceeds will be used to purchase another annuity, could be challenged by the IRS as some form of a step sale. Since it is presumed that any such transaction would involve a totally new contract issued by a different insurer and where the contract features, investment mix and charges would be different from the old contract, it would seem the IRS would have a difficult time trying to assert that the original surrender or sale would not give rise to a tax deduction. However, it is not beyond the realm of possibility that the IRS might try such an assertion.

As we have said before, any owner of an underwater deferred VA who is considering surrendering the contract should evaluate all alternatives, including selling the VA to an unaffiliated third party that might pay a premium for the old VAs death benefit.

In any event, the decision to keep, surrender, sell or exchange a deferred VA will depend on the facts and circumstances in each individual case. Anyone involved should seek knowledgeable advice before a decision is made.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the Pompano Beach, Fla., office of Blazzard, Grodd & Hasenauer, P.C. They can be reached via e-mail at Norse.Blazzard@bghpc.com.


Reproduced from National Underwriter Edition, April 15, 2005. Copyright 2005 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.