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Financial Planning > Tax Planning > Tax Loss Harvesting

Top Story: How to help clients rescue their deferred variable annuity

By David Smucker, Shawn Britt

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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.

What about wash sales? The second strategy was to surrender the annuity to get the loss, and then reinvest part of the proceeds in another annuity, one that might be more attractive or have better living benefits.

That might create a wash sale problem: a loss position in a security in which the owner has long-term faith. The desire is to sell the security to harvest the loss, but then to repurchase the security because of the belief that, in the end, it will be a gainer.

Under IRC Section 1091, if the owner “harvests” that loss and, if within the 61-day period beginning 30 days before the sale and ending 30 days after the date of the sale, replaces the security by acquiring a substantially identical security, then the loss will be disallowed. Further, the cost basis of the replacement security will be the cost basis of the original security increased or decreased by the difference (if any) between the cost of the replacement security and the cost of the original security.

The upshot is that if the replacement annuity is purchased during that 61-day period, the loss may be disallowed. The question of what a “substantially identical security” is becomes one of facts and circumstances and is another decision that has to be left to the taxpayer and the tax preparer.

The investment profession has a duty to disclose the potential wash sale loss disallowance and to suggest how it might be avoided, but the final decision must be made by the client and client’s tax counsel.

Loss and other income: The third issue that arises relates to the size of the potential loss in relation to the client’s other income. As mentioned above, the loss might be so great that it would more than offset the client’s other income. As also mentioned above, given the IRS position that the loss is a miscellaneous itemized deduction subject to the 2% floor, there is no provision to carry any excess loss back or forward to another tax year. In other words, the tax benefit of any excess loss will be lost.

Therefore, an annuity owner might be tempted to do a partial 1035 exchange of some of the annuity into a new annuity, surrender one of them in one year and the second in another year, spreading the losses over more than one year to avoid losing any of the loss deductions.

Here’s an example:

  • Sam is retired and living on a fixed income of about $70,000 a year.
  • He has a $120,000 loss in his nonqualified annuity.
  • With personal exemptions and a standard deduction, he needs only a $60,000 loss to wipe out his income tax liability.
  • If he surrenders the entire annuity, the use of the excess $60,000 of loss could be lost.
  • Sam chooses to do a partial 1035 exchange, putting half of the existing annuity into a new annuity.
  • It’s March 2009. Sam does a partial 1035 exchange now and immediately surrenders one annuity, wiping out his income tax for 2009. Then, in January 2010, he surrenders the second annuity, wiping out his income tax for 2010 (assuming he still has a $60,000 loss in the second annuity).

At this point, Revenue Procedure 2008-24 steps in. The rev proc says that Sam can do what he wants to do, but if either annuity is surrendered within 12 months of the partial 1035 exchange, the two surrenders will be treated as one integrated transaction, as of the date of the 1035 exchange. In other words, the entire $120,000 loss will go on the 2009 return, restoring his 2010 income tax liability.

Therefore, Sam can do the exchange today, but he’ll have to wait more than 12 months, until after March 2010, to surrender one of the annuities. If nothing else changes, he’ll be in a good position to surrender the second annuity in 2011.

Again, this is an item for disclosure to the client and for final judgment and implementation by the taxpayer client and client’s tax counsel.

In conclusion, an annuity that is in a loss position represents an unrealized, paper loss. Only when it is surrendered will the loss become realized.

We have reviewed several tax issues in this article. All of them need to be disclosed to a client who is trying to figure out what to do with his or her under-water annuity. As always, the final decision on tax treatment must be left to the client and the client’s tax counsel.

David K. Smucker, CPA, CFP, CLU, ChFC, and Shawn Britt, CLU, are both directors in Advanced Sales for Nationwide Financial Services, Inc., Columbus, Ohio. Their respective e-mail addresses are [email protected] and [email protected].

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