Because of current market conditions, many deferred variable annuities are under water: The market value of the separate accounts is less than the total investment.
Many annuity owners are fed up with the poor results and want to know if anything can be salvaged from the situation. They would like to move their money into something that’s safer and more conservative. And they want to know if they can deduct the loss if they surrender the VA.
The answer is yes, and the term for the concept is “annuity rescue.” There’s quite a bit associated with this concept. This article will look at three annuity rescue strategies and some related income tax issues.
There are at least three possible annuity rescue strategies one can follow, based on the client’s financial situation and desired outcome. These include:
Full surrender annuity to life:
- Surrender the annuity; and
- Use the proceeds to purchase a single-premium, no-lapse guarantee (NLG) life insurance policy to preserve and possibly exceed the annuity death benefit.
Full surrender annuity to life and annuity:
- Surrender the annuity; and
- Use some of the proceeds to purchase a single-premium NLG life insurance policy to preserve the annuity death benefit.
- Use the remainder of the proceeds to purchase a variable annuity with a guaranteed income rider or other attractive living benefit.
Partial withdrawal of annuity to life:
- Do a partial withdrawal of the annuity contract value to preserve the dollar-for-dollar death benefit remaining.
- Use the proceeds of the withdrawal to purchase a single-premium NLG life insurance policy.
- Move any remaining contract value in the annuity to the fixed account, making sure enough is left in contract to support contract fees.
Here are some things to bear in mind.
As clients’ personal situations change (due to a marriage, birth of a child, job promotion, etc.) so will their life insurance needs. Care should thus be taken to ensure that recommended strategies and products are suitable for their long-term life insurance needs.
Clients should weigh their objectives, time horizon, risk tolerance and associated costs before investing. Also, be aware that market volatility can lead to the need for additional premium payments in the policy.
When evaluating a VA purchase, clients should be aware that VAs are long-term investment vehicles designed for retirement purposes and will fluctuate in value; annuities have limitations; and investing involves market risk, including possible loss of principal.
There are general suitability issues associated with those strategies. Examples are:
- The surrender could trigger non-deductible surrender charges.
- The existing annuity may have valuable benefits that would be lost if surrendered. Note that distributions made prior to age 59 1/2 may be subject to a 10% tax penalty. All taxable distributions at any age are subject to ordinary income tax, and surrender charges may apply.
- The new annuity may have a surrender charge.
- The guaranteed income rider on the new annuity may not perform as well as hoped. The long-term advantage of an optional benefit will vary with the terms of the benefit option, the investment performance of the variable investment options selected and the length of time the annuity is owned. As a result, in some circumstances, the cost of an option may exceed the actual benefit paid under the option.
There are also income tax issues to consider. Here are three significant ones, plus comments on each:
- Is the loss on the surrender of the annuity deductible?
- Might the wash sale loss disallowance rules come into play in the second strategy?
- If the loss is too big, should a partial 1035 exchange be considered, so the owner can take part of the loss in one year and the rest in another year?
Regarding surrender: Revenue Ruling 61-201, 1961-2C.B. 46 deals with the surrender at a loss of a refund annuity. The ruling concludes that if an annuity is a transaction entered into for profit, which was the case in that revenue ruling, then the loss on surrender is deductible and is an “ordinary” loss.
Unfortunately, the revenue ruling doesn’t say how the loss is to be deducted on the income tax return. Further, there have been no subsequent revenue rulings or revenue procedures to tell where or how the loss is deductible. The only guidance is the word “ordinary,” the treatment of income from an annuity, and IRS Publication 575, “Pension and Annuity Income.”
Since the revenue ruling calls it an ordinary loss, some commentators believe the loss is fully deductible in determining gross income. They point to the fact that the taxable portion of an annuity payment is part of gross income and contend that consistency requires that losses on annuities should also be included in the calculation of gross income.
But the IRS position is reported on page 21 of the 2008 revision of Publication 575, in a TIP notation, which states the loss is treated as a miscellaneous itemized deduction subject to the 2% floor. Itemized deductions are deductions from adjusted gross income (AGI). Admittedly a comment in an IRS publication isn’t a revenue ruling or revenue procedure, but it is a pronouncement of the Internal Revenue Service.
Several things make a miscellaneous itemized deduction subject to the 2% floor unattractive:
–One has to itemize deductions.
–Deductions have to exceed 2% of AGI.
–Deductions are not deductible for alternative minimum tax purposes.
–There is no provision permitting the carry-over or carry-back of losses that more than offset taxable income.
Who decides how to treat the loss? Ultimately, it will be the people who sign the tax return: The taxpayer and the tax return preparer. They face the potential liability for the additional income tax, interest and possible penalties.