A big tax issue for many investors is whether or not losses in a Variable Annuity are deductible.
It is possible to deduct a variable annuity loss. There is some disagreement, however, over where on the tax return to deduct the loss.
To deduct the loss, the annuity has to be sold (liquidated). Shifting investments among the investments offered in the annuity is not enough; neither is shifting from one variable annuity to another in a tax-free exchange. If the variable annuity imposes a surrender charge when the money is withdrawn, that surrender charge is not part of the deductible loss.
Suppose $100,000 was invested. The annuity’s value now is $80,000 and there will be a surrender fee of $5,000. The investor will receive $75,000 by liquidating the annuity. The deductible loss is $20,000. If you are under age 59 1/2, there is no early distribution penalty, because that is imposed only on gains that are withdrawn, not principal.
Most tax advisors believe that the loss is a miscellaneous itemized expense, deductible only if you itemize deductions on Schedule A. In addition, there is a limit on miscellaneous expenses. Only the portion of the expenses that exceeds 2% of adjusted gross income is deductible. If AGI is $50,000, the first $1,000 of miscellaneous expenses generates no tax benefit. There is no deduction if the total miscellaneous itemized expenses for the year are less than $1,000. Another potential problem is that anyone subject to the alternative minimum tax loses all miscellaneous itemized expense deductions.
The good news is that the presence of the loss might allow you to get deduct miscellaneous expenses that fell under the 2% floor in past years.
Some tax advisors advocate a more aggressive and more beneficial approach. They say that an annuity loss can be deducted under “Other Gains/Losses” in the first section of the tax return. This loss is deducted before adjusted gross income, along with capital gains and losses, business gains and losses, and sources of income. They say Revenue Ruling 61-201 supports this treatment.
If you lean toward the second approach, it is worth discussing it with a tax advisor or two before taking action. If the IRS audits the deduction (likely if it is a large loss), you’ll want a tax pro who will defend the treatment to the auditor in tax language.