Don’t Like Your Annuity?

Annuity Contracts in Loss Positions

Here's a hypothetical case:

In 2005, Mr. and Mrs. Smith, a married couple, purchased a nonqualified deferred variable annuity contract issued by the Brand X Company with a single premium payment of $100,000. Unfortunately, as of December 1, 2008, the cash value of this Brand X annuity is only $80,000. In addition, the contract's surrender charge still applies, and the cash surrender value is only $76,000. Both Mr. and Mrs. Smith are age 50 and, for 2008, they anticipate their combined IRS Form 1040, line 37 adjusted gross income (AGI) to be $150,000.

What options exist for the Smiths?

While surrendering the contract may help them recoup some of the loss through income tax benefits we'll discuss below, providing definitive guidance is really a case-by-case proposition that a client's tax professional can help determine. There are many issues to consider.

Is the loss deductible?

There is little guidance from the IRS regarding losses on annuities. Recently, the IRS added a sentence in Publication 575, Pension and Annuity Income, page 20, that indicates that a loss from a complete surrender of a deferred annuity is a miscellaneous itemized deduction, subject to the 2% floor. Other tax practitioners might take a different position and deduct the loss as negative annuity income on the front of Form 1040.

What's the characterization and amount of the loss?

Annuity losses are ordinary losses. They are never considered capital assets, regardless of the client's holding period. Accordingly, annuity losses are not recognized on Form 1040, Schedule D, aggregated with short or long term capital gains or losses, or subject to a $3,000 annual loss limitation.

How is the loss realized?

You can only realize and deduct a loss if you surrender the entire contract. Beware the AMT (alternative minimum tax). Miscellaneous itemized deductions subject to the 2% floor, as well as other AMT preference items, are added back to gross income to determine AMT tax liability. Thus, for our high-income-earning clients who are AMT filers, the AMT might reduce the value of the loss deducted.


What's the best Approach?

A 1035 exchange with carryover cost basis

Surrendering the contract and deducting the loss may not be the most efficient use of the loss, since the deduction is reduced by 2% of AGI, and may be lost through the AMT. Another way to carryover the loss is to make a 1035 exchange into a new, better-performing annuity. The new annuity will carry over the tax characteristics of the old annuity, including the built in loss. Depending upon the performance of the newer contract, it may be able to grow back up to basis without any reportable income.


For example, suppose the Smiths bought a variable annuity with $100,000 premium. In a rough market the value of the annuity fell to $80,000. Since their current contract is past the surrender charge period, they want to move to something more conservative with better guarantees and benefits. The Smiths 1035 exchange the old annuity for a new annuity. They have $80,000 to pay for the new annuity when the exchange occurs. Yet because this is a 1035 exchange, they get to carry over their $100,000 basis. The new annuity has an $80,000 cash value and a $100,000 basis. Therefore, the new annuity can grow by $20,000 until its cash value reaches its $100,000 basis, before any distributions include taxable gain. In this situation, the carryover cost is a benefit for the Smiths. None of the built in loss is disallowed by the 2%–of–AGI limit or the AMT.


This has been a tough year for the economy. While no one likes losses, the tax rules can ease the pain a bit. You may be able to get an immediate deduction by surrendering the contract for a loss. You might lose some of the value from the loss, though, because of the 2%-of-AGI floor and the AMT. Or, you can carryover the cost basis by exchanging the annuity and letting the new contract grow back up to basis.

Please remember that surrendering a contract is giving up the income guarantees and death benefit options that may be available with a particular product. Therefore, the tax considerations are just one of the many issues that must be considered when reviewing the overall performance and benefits of an individual annuity contract.