Q: What happens if I cash in an annuity at a loss?
Amy, Woodbridge VA
A: This is actually a disputed question within tax practice, albeit one that does not come up often. Some tax preparers suggest taking this as negative income in "other income." Others would consider this to be a "miscellaneous itemized deduction," subject to the limits...
An annuity is a type of insurance contract that promises to pay out a return after a number of years. One popular (though financially reckless) type of annuity is a "variable annuity." These plans, which act like very, very expensive mutual funds, fluctuate up and down with their underlying investment.
Like any investment, then, bailing out on a variable annuity may cause a loss of your initial investment. What to do with this loss? Is it deductible?
The answer can be found in IRS Revenue Ruling 61-201, which deals with this very matter.
The ruling states that if there is a complete surrender of the annuity, and there is a loss (defined as what you get back minus what you paid for it, with some twists and turns), then you have an "ordinary loss." This is distinct from a "capital loss," where the rules would be somewhat different.
So far, so good. If you invest $10,000 in a variable annuity and get $6000 back, you have a $4000 ordinary loss which is deductible against ordinary income. The question is, "where?"
Some ordinary losses (business losses, for example) are deductible on Page 1 of the 1040 (so, against gross income). Other ordinary losses (depreciation on an employee's home office, for example) are "miscellaneous itemized deductions." Some of these face a 2% of AGI threshold, requires taxpayers to itemize their deductions, are phased out based on income, and disallowed if the taxpayer is in AMT.
The IRS provides no guidance on the placement matter. The instructions to Schedule A (Itemized Deductions) neither lists this deduction under those subject to the 2% of AGI limit, nor those free of that limit. The Form 1040 instructions are silent about placing these as an "above the line" adjustment.
That leaves this undisputed ordinary loss without a definite home. There are three options, then, based on the aggressiveness of the taxpayer:
- Deduct it as an adjustment to income on the 1040. This will lower AGI, and cannot be disallowed by AMT or any other provision. Taking the deduction here (which is apparently common) would come under the rule "claim it if not disallowed."
- Deduct it as a miscellaneous itemized deduction not subject to the 2% of AGI threshold. This would be the middle ground. The taxpayer will have to itemize deductions, and this gets phased out based on income. AMT will also disallow this.
- Deduct it as a miscellaneous itemized deduction subject to the 2% of AGI threshold. For the most timid taxpayer. This has all the downsides of #2, but also becomes (along with all other aggregated deductions in this category) subject to the 2% of AGI threshold.
If it were me, I would lay out all options for the taxpayer first. Then, I would recommend taking the aggressive approach. The worst the IRS can say is "no." Given an ambiguity in the rules, why not go for the biggest advantage?
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