Are Surrender Charges on a Qualified Annuity Tax-Deductible?

You can own an annuity in an individual retirement account or employer plan. Such annuities are “qualified,” because they meet certain Internal Revenue Service requirements. You can surrender a qualified annuity before it begins to pay out, but you might have to pay substantial charges. Surrender charges on a qualified annuity are not tax-deductible, but you might be able to deduct an IRA loss.

Qualified Annuities

A qualified annuity is issued in your name as the owner. You or your beneficiaries are the only ones who can receive payouts from the annuity. The annuity issuer, normally an insurance company, can’t cause you to forfeit your interest in the annuity. You may not transfer the annuity to another owner and must observe the contribution limits for the account holding the contract. You also must begin taking annuity payments by April 1 of the year following the one in which you reach age 70 1/2. You can’t borrow from an IRA annuity, but may be able to do so from an employer plan annuity.

Costly Surrender

Annuities normally have two phases. You build up the cash value during the accumulation phase. On the annuity date, the insurance company confiscates the cash value and begins making monthly payments. This is the distribution phase. Payments last for a fixed period or for the rest of your life. A survivor annuity continues to pay the same or different amounts to your beneficiary. You can surrender the contract during the accumulation phase and receive its cash value minus the surrender charge. This charge might easily exceed 5 percent of your cash value.

Rollovers

If the insurance company sends you a check for the surrendered cash value of your qualified annuity, you have 60 days to deposit it into an IRA or employer plan to avoid taxes. If you are younger than 59 1/2, you also might have to pay a 10 percent penalty for an early withdrawal if you miss the deadline. If the insurance company instead pays the proceeds directly to your employer plan or IRA, your custodian will handle the tax-free transaction. If you are surrendering your plan because you’re unhappy with its features or expenses, you might consider a Section 1035 exchange. Under this rule, you have the right to exchange your annuity for another one. However, surrender charges may apply.

IRA Loss

If the balance in your IRA falls below its cost basis because of a large surrender charge, you can empty out the IRA and deduct the loss. This normally only works for a Roth IRA annuity, because in this type of IRA, your cost basis is equal to your total contributions. Your traditional IRA may have a cost basis if you contributed in a year in which you or your spouse belonged to an employer plan and your gross income exceeded certain limits. Figure your loss by subtracting the total IRA distribution from your cost basis. The loss is a Schedule A miscellaneous itemized deduction subject to a threshold of 2 percent of your adjusted gross income.

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