This week, Gail explains two methods to handle losses on a variable annuity. It's complicated -- but well worth exploring for the significant tax savings it could represent for many investors.

 

Dear Gail,

In late 1999, at the top of the stock market (of course), I invested in a variable annuity. I put all $80,000 into three stock funds. Like everyone else, my investments are under water. My "cash value" is now $60,000. I'd like to sell the VA and take my loss as a tax deduction, but no one, including my tax advisor, can tell me if this is legal. Can you help?

Thanks,

Katie

 

Dear Katie,

Don't be too hard on your tax advisor! There is a great deal of confusion on this issue. The problem is that the tax code does not specifically address the issue of recognizing a loss in a variable annuity. There are two schools of thought in the tax world as to how this should be handled. I'll lay out both positions and let you make your own decision.

One thing the experts I spoke with agree on is that you can write off a loss you have in a variable annuity (VA). They only differ on how to go about doing this.

For those who might not be familiar with them, variable annuities, in their most basic form, combine investments managed in the same style as mutual funds -- technically called "sub-accounts" -- with a life insurance policy. The returns the sub-accounts earn vary based upon what they're invested in. Thus, the name "variable" annuity.

VAs were approved years ago by Congress primarily as a means to save for retirement. That's why the gains your investments earn are not taxed until you begin withdrawing money, presumably in your later years.

Thanks to the life insurance component, when you die, your heirs are guaranteed to receive a pay-out worth no less than the amount you invested in the VA (minus any withdrawals you made while alive), regardless what the sub-accounts are actually worth.

Let's take your case. You contributed a total of $80,000 to your variable annuity when you opened it. Assuming you did not add any more money, your "cost basis" in the VA is $80,000. If you were to die tomorrow, the person named as the beneficiary of your account would receive a check -- life insurance proceeds -- in the amount of $80,000 even though the investments in the annuity are currently only worth $60,000.

In order to encourage people to use a variable annuity for its intended purpose, the government hits you with a 10% penalty if you withdraw any gains prior to age 59 1/2. In addition, the company which sponsors the annuity typically imposes a "surrender charge" if you make any withdrawals within the first 5 to 7 years after you open the account.

VAs have come a long way in the past ten years, and now offer a variety of special features. Some will waive the surrender charge if you need to withdraw money to pay for nursing home costs or if you don't take out more than, say 10%, a year. If your account does well (let's hope there are better times ahead), many variable annuity sponsors will periodically increase the death benefit so it equals the actual account value instead of your original cost basis. And this is a one-way street: once your death benefit is raised, it can never decrease, even if your investments subsequently go down.

For an additional cost, some variable annuities will guarantee a minimum return. For instance, this option might say provide you with either the actual return your portfolio earns or a minimum of 5% per year -- whichever is higher. As I wrote about in June, this feature protects you from a bear market like we've had for the past two and a half years.

But, in my opinion, the main benefit of any variable annuity is that it gives you the right to "annuitize" the contract at some point. This means that you turn the value of your annuity over to the insurance company. In exchange, it is bound to pay you a specific income for as long as you live or for some other period of time such as 10 or 15 years. In other words, by annuitizing you can guarantee you'll receive income for life.

I sympathize with your situation, Katie. While your VA would be worth $80,000 to your beneficiary if you died (thanks to the life insurance), if you cash it in while you're alive, you will only receive the actual market value of $60,000. In other words, in order to get your original $80,000 back you'd have to die -- not a good option!

As you suggest, there is a way to possibly use this to your advantage by declaring the variable annuity a "loss" and using this to reduce your income taxes.

First, you have to sell the annuity. (You are not allowed to recognize either a gain or loss on an annuity if you use a technique called a "1035 exchange.") Think twice before you do this! If you have only owned your VA for a few years, there could be a surrender charge imposed by the annuity provider. And this is not deductible.

To calculate your gain or loss, you have to figure your "cost basis." This is the total amount of principal you contributed, minus any withdrawals you made. From this, subtract the proceeds from the sale. If you paid a surrender charge, you have to add this back in.

Using your example, we'll assume your total contribution to your variable annuity was $80,000, that you didn't take any withdrawals, that the annuity is worth $60,000 on the day you cash it out, and that you have to pay a $2,000 surrender charge for canceling the contract early.

Although you receive a check for $58,000, your reportable loss is $20,000 -- not $22,000. The $2,000 surrender charge is not considered part of your loss. One bright spot: even if you are under age 59 1/2, there will be no 10% early withdrawal penalty from by the federal government because, as mentioned above, this is only imposed on gains.

Now here's where we enter the "murky" zone: Where on your tax return do you report this loss?

A loss on a variable annuity is not considered an "investment" loss. You cannot use it to offset income from investments such as mutual funds or the profit you realized from the sale of stock. Instead, it is classified as an "ordinary" loss, which means it is (potentially) fully deductible in a single tax year.

The conservative approach is to treat your VA loss as a "Miscellaneous Deduction" (Line #24 on Form 1040 for 2001). This means you have to lump it in with all your other Itemized Deductions. And you will only get a deduction to the extent that your total Itemized Deductions exceed 2% of your Adjusted Gross Income (AGI).

For instance, if your AGI is $100,000 and your $20,000 VA loss is the only item you have under "Miscellaneous Deductions," you will only be allowed to deduct $18,000 -- not the entire amount. That's because you get no deduction for the first $2,000 in losses ($100,000 x 2%).

Worse, if you, like millions of middle class taxpayers, are subject to something called the "Alternative Minimum Tax," you lose the ability to deduct any "Miscellaneous Deductions." So be sure to check if this applies to you.

Now here's the more gutsy approach: Instead of listing your annuity loss as a "Miscellaneous Deduction," some tax experts think it is more appropriate for it to be listed under "Other Gains/Losses" (Line #14 on Form 1040 for 2001). An IRS Revenue Ruling that dates back to 1961 seems to support this approach.* In fact, some tax advisors are going so far as to make a copy of this decision and attaching it to their client's tax returns.

Joe Stenken, a tax expert with the National Underwriter Company and one of the authors of the firm's annual "Tax Facts" handbook, says this approach allows you to deduct the entire amount as a loss because there is no 2% limit. Furthermore, items in the "Other Gains/Losses" category don't disappear even if you're subject to the Alternative Minimum Tax.

A word of caution: This is complicated stuff. Do not try this on your own! By all means make sure you seek the help of an experienced tax professional and investment advisor.

By the way, if you take the more aggressive approach and happen to end up in tax court, you will not only be immortalized in the annals of Tax History, you will become a saint of sorts to those who toil in the tedious theater of tax law: every CPA in America will appreciate you settling this issue once and for all!

Take care,

Gail

 

*Revenue Ruling 61-201, 1961-2, CB46. You can look it up in the IRS records or buy a copy of National Underwriter's "2002 Tax Facts 1."

 

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