How to Take a Loss on an Annuity

by Leslie McClintock

If you have a variable annuity that has lost a significant percentage of its value compared to the total premium you have invested in it, it may be tempting to cash in that annuity and start fresh. Before you do so, be sure you understand the possible consequences of cashing in, or surrendering, an annuity contract.

Basis Basics

If you sell an investment for more than you bought it for, the Internal Revenue Service (IRS) charges a capital gains tax on your profit. The way they calculate the tax is by subtracting the price you receive for the investment or property from the total number of after-tax dollars you have invested. The higher your basis in the property, the lower your taxable profit, and therefore, the lower your tax bill. Tax deductible dollars typically don't count towards your basis.

Annuities and Basis

Most property or investments you hold for longer than one year qualify for the long-term capital gains rate. As of the time of publication, the maximum capital gains tax rate is 15 percent. However, annuities fall into a different category: If you sell an annuity, the IRS assesses ordinary income tax rates, rather than capital gains rates. The maximum income tax rate is 35 percent, as of the time of publication. This works against you when you sell at a profit, but it is an advantage if you sell at a loss. However, unlike with other types of investments, you cannot carry annuity losses forward to offset gains and income in future years.

Surrendering Annuities

Remember, annuities are intended to be long-term investments, and they are designed not to be speculative vehicles, but to generate a stream of income later in life. Congress discourages the early surrender of annuities by charging a 10 percent penalty on annuity withdrawals prior to age 59 1/2 in most cases. Furthermore, because of the commission structure on annuities, annuity companies charge a percentage of the contract in fees if you surrender the contract during the surrender charge period, which can last anywhere from one to 13 years after you make the purchase. If few years have elapsed since you bought the annuity, look at the terms of your contract for surrender provisions.

Taking a Loss

If you decide that taking a 10 percent penalty and paying any applicable surrender charges will be worth it, contact the insurance company that sold you the annuity and let them know you want to surrender the annuity. They will have an agent contact you, or they will send you a written contract to sign. When you file your taxes, you can deduct any losses as a miscellaneous itemized deduction on Schedule A of your U.S. Individual Income return, in accordance with Section 165 of the Internal Revenue Code.

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