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Annuities occupy an odd position in the tax code. Although investors often regard annuities like other capital investments, annuities generate ordinary income rather than preferentially taxed capital gains. While this allows a loss on an annuity to decrease the investor’s ordinary income, it renders fees paid on an annuity non-deductible. Instead, fees paid on an annuity simply decrease the annuity’s return on investment.
The language of the tax code can be vague at times. Often that’s intentional, providing more leeway for the Internal Revenue Service and the courts to hash out the details with their in-depth technical knowledge. Section 212 provides a deduction for expenses “(1) for the production or collection of income; (2) for the management, conservation or maintenance of property held for the production of income; or (3) in connection with the determination, collection or refund of any tax.”
Owners might argue that certain annuity fees, such as management charges, are ordinary and necessary expenses “for the production or collection of income” and qualify as deductions. Investment management fees, after all, are typically deductible. However, annuities are considered as a whole, and fees charged from the account are taken as part of the income the annuity produces. Other fees, such as premiums for riders, are consideration given in exchange for a contractual benefit and so can’t be deducted.
An annuity is, however, property held for the production of income. Although internally charged fees are taken as a part of the income produced by the annuity – and cannot be deducted as Section 212 expenses – if a taxpayer had a managed portfolio that consisted of annuities, he could deduct the management fees paid to his portfolio manager. The fees would be deducted on a Schedule A and subject to a reduction by 2 percent of adjusted gross income.
In the unenviable circumstance that a taxpayer were to realize a loss because of fees, such as if he closed out an account with little gains and significant surrender charges, then the loss would offset the owner’s ordinary income. A deduction for an annuity loss takes place in calculating the adjusted gross income, so the taxpayer can take it even without itemizing deductions. Although a taxpayer can deduct the unrecovered basis on a loss, he couldn’t recover any gains wiped out by the fees.
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