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Year-End Tax Planning: Are Variable Annuity Losses Deductible?

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December 6, 2011 • Reprints

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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. 

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, AdvisorFX, for a free trial.

You may also be interested in signing up for a free trial with another Summit Business Media partner, Tax Facts Online.

See also The Law Professor's blog at AdvisorFYI.

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About the Author
William H. Byrnes, Esq.

William H. Byrnes, Esq.

Prof. William H. Byrnes, Esq., LL.M., CWM, Fellow

Prof. William H. Byrnes, Esq., LL.M., CWM, Fellow, is the leader of Summit Business Media's Financial Advisory Publications, having been appointed July 1, 2010. He has been an author and editor of 10 books and treatises and 17 chapters for Lexis-Nexis, Wolters Kluwer, Thomson-Reuters, Oxford University Press, Edward Elgar, and Wilmington, as well as numerous commissioned, peer-reviewed, and law review articles. He was a Senior Manager, then Associate Director of international tax for Coopers and Lybrand, which subsequently amalgamated into PricewaterhouseCoopers, practicing in Africa, Europe, Asia, and the Caribbean.

He has been commissioned and consulted by a number of governments on their tax and fiscal policy from policy formation to regime impact. He has served as an operational board member for companies in several industries including fashion, durable medical equipment, office furniture, and technology. Since 1994, he has been a professional trainer for professional association conferences, government workshops, and financial service institutions in-house meetings.

Before Associate Dean Byrnes joined the administration of Thomas Jefferson School of Law, he was a tenured law faculty member at St. Thomas School of Law. He serves on the Academic Committee of the American Academy of Financial Management. He created the first online graduate program offered to wealth managers and life insurance producers without any legal background—see http://llmprogram.tjsl.edu (Graduate Program of International Tax and Financial Services, Thomas Jefferson School of Law).

Email: wbyrnes@nationalunderwriteradvancedmarkets.com

About the Author
Robert Bloink, Esq., LL.M.

Robert Bloink, Esq., LL.M.

Robert Bloink is a professor of tax for the Graduate Program of International Tax and Financial Services, Thomas Jefferson School of Law.

Previously, he served as Senior Attorney in the IRS Office of Chief Counsel, Large and Mid-Sized Business Division, where he litigated many cases in the U.S. Tax Court, served as Liaison Counsel for the Offshore Compliance Technical Assistance Program, coordinated examination programs audit teams on the development of issues for large corporate taxpayers, and taught continuing education seminars to Senior Revenue Agents involved in Large Case Exams. In his governmental capacity, Mr. Bloink became recognized as an expert in the taxation of financial structured products and was responsible for the IRS’ first FSA addressing variable forward contracts. Mr. Bloink’s core competencies led to his involvement in prosecuting some of the biggest corporate tax shelters in the history or our country.

 

Mr. Bloink's insurance practice incorporates sophisticated wealth transfer techniques, as well as counseling institutions in the context of their insurance portfolios and other mortality based exposures. 

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