Offset a Roth conversion with annuity losses

October 12, 2011 | Putnam Investments

With all the recent market volatility, you may have clients who own variable annuities whose current value is significantly lower than the original purchase price. One option is to surrender the annuity contract, in which case the remaining principal is returned to the investor, minus any surrender charges. The loss on the contract (which excludes the surrender charge) is considered an ordinary loss, not a capital loss. Since it is an ordinary loss, there are no restrictions on offsetting ordinary income (for example, taxpayers are limited to using only $3,000 of a net long-term capital loss against ordinary income). For this reason, this ordinary loss may be used to offset the income reported on a Roth IRA conversion. Keep in mind that complex rules exist on whether to claim the loss as a miscellaneous 2% deduction, so be sure to consult with a tax professional. Although federal tax law is unclear, there are generally two options for reporting losses from annuity contracts:

Conservative approach: report the loss as a miscellaneous 2% deduction The loss would be reported on line 23 of Schedule A (IRS Form 1040) – Itemized Deductions. Miscellaneous 2% deductions are aggregated and reduced by 2% of the taxpayer’s AGI. Also, a taxpayer subject to the alternative minimum tax (AMT) loses the opportunity to benefit from these types of deductions.
More aggressive approach: report as an ordinary loss not subject to 2% limitation In this case, the loss would be reported on line 14 of IRS Form 1040 – Other gains or (losses). Unlike a miscellaneous 2% deduction, ordinary losses are not disallowed under the AMT system. Some tax preparers cite a 1961 IRS revenue ruling (61-201)as precedent for this approach, but it is important to note that miscellaneous 2% deductions did not exist at the time of the revenue ruling.

Lastly, there may be other considerations for maintaining an annuity contract in spite of the fact that a loss exists. For example, there may be an attractive death benefit or certain guaranteed income benefits which would cease once the contract is surrendered.