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Winning Strategies for Annuity Losses

Stuck with an annuity worth 50% of your original investment? Surrendering or exchanging a portion of the annuity may help you recoup some of these losses.

The stock market bubble of the late 1990s brought with it an unprecedented increase in variable annuity sales. Before 1990, annual variable annuity sales in the United States had never exceeded $10 billion. By the late 1990s, annual sales were well in excess of $100 billion. Unfortunately, when the bubble burst, so did the values of most variable annuities, leaving their owners with significant losses. Annuity holders can find some solace, however, as there are a couple of options for turning lemons into lemonade.

Surrendering The Annuity

The first option for a holder of a non-employer-sponsored annuity is to surrender it, which can provide a tax benefit. Straightforward as this may seem, a number of factors must be considered. Tax experts have long debated the proper tax treatment of an annuity surrender.

Surprisingly, there is no section of the Internal Revenue Code that specifically addresses how a loss on the surrender of a variable annuity is recognized. While an official IRS ruling has been anticipated for some time, the Service has thus far largely left American taxpayers to fend for themselves.

The most widely accepted treatment is to report the loss as a miscellaneous itemized deduction. There is no official IRS confirmation of this position, but Bruce I. Friedland, a spokesman for the IRS, was quoted in a Wall Street Journal article on Dec. 6, 2002, as saying the IRS has accepted this treatment in the past and will continue to do so.

This treatment has some potential drawbacks for taxpayers. First, you will not receive any tax benefit unless the deductible loss, when combined with your other miscellaneous deductions such as tax preparation and investment management costs, exceeds 2% of your adjusted gross income. The higher your income, the less likely you are to benefit by claiming a miscellaneous deduction for your loss on a surrendered annuity.

Second, increasing your miscellaneous itemized deductions may be of little or no benefit if you are subject to the alternative minimum tax.

Finally, most annuities have "surrender charges," or fees for the early termination of the annuity contract. A common structure for surrender charges is 7% of the annuity value in the first year, declining by 1% for each subsequent year. For an annuity worth $1 million, this could mean surrender charges of anywhere from $10,000 to $70,000 if you are still in the surrender charge period. Any of these factors, or a combination, could negate any benefit and actually leave you worse off after surrendering the annuity than you were before.

The second, more aggressive tax treatment is to deduct the loss directly from your gross income under "Other Gains/Losses" on line 14 of the 1040. If this treatment is accepted, you would avoid the 2% restriction for miscellaneous itemized deductions and significantly reduce alternative minimum tax concerns, although you will still be subject to potential surrender charges. Accountants who have used this method go back to an obscure Treasury ruling from 1961 to find justification for this treatment, and it is thin, at best. The IRS probably would argue that this treatment cannot be used for nonbusiness assets, including most annuities.

Partial Exchanges

If surrendering the annuity does not look like a good option, there is an alternative. One of the major selling points of annuities is the minimum death benefit option that most have. (For an explanation of the structure of variable annuities, see Jonathan Bergman’s article, "A Promising Investment And Cutlery, Too.") Depending on the language of your annuity contract, you may be able to significantly increase your death benefit by exchanging most of your annuity for a second annuity, a transfer known as a partial exchange. A partial exchange, allowed under Section 1035 of the Internal Revenue Code, can be beneficial because many annuity contracts guarantee a minimum death benefit equal to the greater of the value of the annuity or the amount invested, less any withdrawals.

Take John Q. Public, for example, who purchased annuity A for $1 million at the peak of the stock market and subsequently watched the value drop to $700,000. The guaranteed death benefit on annuity A remains $1 million. Now John decides to do a partial exchange. He transfers $690,000 from annuity A to a new annuity, annuity B.

After the exchange, annuity A has a balance of $10,000 with a death benefit of $310,000 ($1 million less the $690,000 that was withdrawn). Now assume that the investments gain 50% over the remainder of John’s life. The $690,000 transferred into annuity B has grown to $1,035,000, while annuity A’s death benefit has remained unchanged at $310,000. John’s total death benefit between annuities A and B is $1,345,000 ($1,035,000 plus $310,000).

If John had just held the original annuity, the $700,000 value would have grown to $1,050,000, giving John’s beneficiaries a death benefit of $50,000 more than he originally invested. With the partial exchange, the net annuity values have remained the same, while the death benefit has increased by $295,000. The death benefit can be increased with few costs, if any. The fees for setting up the second annuity should be minimal (consider a no-load annuity offered by Vanguard). Some surrender charges may exist if the annuity is still in the surrender period and should be evaluated before surrendering the policy.

Scenario 1: JQP keeps the original annuity
Purchase price of annuity$1,000,000
Value of annuity after market decline$700,000
Death benefit after market decline$1,000,000
Value of annuity after 50% gain$1,050,000
Death benefit after 50% gain$1,050,000
Scenario 2: JQP executes a partial exchange
Purchase price of annuity$1,000,000
Value of annuity after market decline$700,000
Value of annuities A & B after partial exchange$10,000 & $690,000
Death benefit of annuity A before 50% gain$310,000 ($1,000,000 - $690,000)
Death benefit of annuity B before 50% gain$690,000
Value of annuities A & B after 50% gain$1,050,000 ($15,000 & $1,035,000)
Death benefit of annuity A after 50% gain (unchanged)$310,000
Death benefit of annuity B after 50% gain$1,035,000
Total death benefit$1,345,000

For a partial exchange to work, the annuity contract must include a provision that stipulates a dollar-for-dollar reduction of the death benefit when cash is withdrawn from the contract. As you have probably already guessed, insurance companies have caught on to this loophole and have restructured new contracts to reduce the death benefit on a percentage-of-withdrawal basis rather than a dollar-for-dollar basis. In John Q. Public’s example, the annuity value was reduced by 98.6 percent because of the withdrawal. Using the percentage basis, the death benefit of the annuity would also be reduced by 98.6 percent, from $1 million to $14,000. But if you bought your annuity a few years ago, the dollar-for-dollar death benefit reduction may still be an option.

While it is clear that there are potential benefits to surrendering your annuity or doing a partial exchange, neither decision should be taken lightly, given the potential complications. Consult your tax or financial advisor to see whether either option makes sense for you.

Vice President David Walters, who is based in our Oregon office, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 5, “Estate Planning,” and Chapter 6, “Transfer Taxes.” He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.