After months of losses in his variable annuity, your client comes to you asking whether it’s time to move his money to greener pastures. How do you proceed? You may not be in the business of giving tax advice, but the move will be heavily influenced by the tax consequences of the loss. Can the loss be deducted? And if so, how much will of the loss can be deducted, and is it a capital or ordinary loss? The final question that should come to mind is whether the conversation is a selling opportunity in disguise.
What if the fair market value of your client’s variable annuity (VA) falls from $100,000 to $60,000? The good news is that a loss in a variable annuity is deductible—although there’s no solid answer on the mechanics of deducting the loss.
The first requirement for deducting the loss is common to all losses: you’ll need to realize the loss before the loss can be recognized for income tax purposes. The principle is the same as for stock losses; if the value of your Microsoft stock drops 15%, you don’t get to deduct the loss unless you sell the stock and realize the loss. The same holds true for a variable annuity. If the value of the VA has dropped 40% to $60,000, you can’t deduct the loss until you realize it.
How are losses in a VA realized? Like stock, your client must “sell” the annuity to recognize the loss for tax purposes. That sale will probably be in the form of a surrender to the carrier; a 1035 exchange isn’t going to cut it. The unfortunate part of the equation is that the hefty surrender charge your client may be charged won’t be deductible.
Simplifying a bit, the amount of the loss that your client will recognize is the basis in the annuity minus the amount received on its surrender (disregarding any surrender charge). For example, if your client purchased a variable annuity for $100,000, takes no withdrawals or payments from the contract, and then surrenders it, receiving a total of $60,000 from the carrier (including a $4,000 surrender charge), he has a financial loss of $40,000. But his tax loss is going to be limited to $36,000 because the $4,000 surrender isn’t deductible.
The IRS Ruling on a VA as an Investment for Tax Purposes
The confusion surrounding loss deductions for a VA has to do with how the loss is reported. The loss definitely isn’t an investment loss, so it can’t be deducted against losses on stock and mutual funds. But that’s not necessarily a negative. The loss is deductible as an ordinary loss, and may be fully deductible in the year it’s incurred. In Revenue Ruling 61-201, the IRS considered whether a loss on what was referred to as “a single premium refund annuity contract” was deductible as an ordinary loss. The IRS’s reasoning was that, under Section 72, an amount not received as an annuity is taxable as ordinary income, and that a loss received under a contract should be given the same treatment—as an ordinary loss. That ruling appears to hold true only for annuities that have a refund feature. The refund feature eliminates the insurance aspect of the contract, and the assumption is that the contract was thus entered into as an investment.
The open question is whether the loss should be reported as a Miscellaneous Deduction or under Other Gains/Losses on a tax return. If the loss is classified as a miscellaneous deduction, it’s going to be subject to the 2% floor and won’t be deductible for alternative minimum tax (AMT) purposes. Classifying the loss as “Other” is a bit riskier from an IRS examination perspective, but if it’s classified that way it will be fully deductible (no 2% floor) and will still be deductible for AMT purposes.
Obviously, your clients will want to classify the loss as “Other,” but there’s no clear authority for that move.
When a Tax-Free Exchange Isn’t a Good Idea
When we think about moving money out of an annuity or life insurance product, we often think first of a 1035 exchange. But when it comes to a variable annuity holding significant losses, a tax-free exchange probably isn’t the best option for your client. Instead, they can take the loss on the VA by surrendering it to the carrier and then move its value (less any surrender charges) into a better-performing product.
A big stumbling block to a 1035 exchange often is the surrender charge that the client will pay on the old annuity. If the loss is significant enough, however, the tax savings may more than set off the surrender charge. A $20,000 loss, for instance, could reduce your client’s tax bill by as much as $7,000.
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See also The Law Professor’s blog at AdvisorFYI.