Annuities provide investors with an attractive tax benefit – they grow tax deferred. While annuities are traditionally a more conservative, low-risk investment, certain types of annuities are designed to offer more exposure to the rhythms of the market. Variable annuities, unlike other types of annuities, can actually decrease in value if the market goes down. Although you must report it differently, like any investment, you have to cash out before you can report a loss from your annuity on your taxes.
Realizing a Loss
You have to sell or exchange your way out of the annuity before you can recognize the loss on your taxes. The loss you realize is the difference between the amount you had invested in the annuity, your basis, and what your selling price. For example, if you purchased a variable annuity for $25,000 and surrender it for $15,000 several years later without ever having withdrawn anything from it, you would realize a $10,000 loss.
One of the disadvantages of annuities is that they are typically subject to significant surrender charges for many years. Some annuities can have surrender charge schedules that take up to 12 years to fade away, and can run as high as 20 percent. Unfortunately, any surrender charge incurred when cashing out your annuity is not tax deductible. So if $3,000 of your $10,000 loss came from surrender charges and penalties, then only $7,000 is deductible as a loss.
Another often-cited disadvantage to annuities is that income from an annuity counts as ordinary income, as opposed to capital gains income like most investments. When you lose money, however, this tax treatment becomes a real advantage because the usual limitations on investment losses don’t apply. While capital losses can only offset ordinary income by $3,000 per year, annuity losses reduce ordinary income first.
How to Claim
When it comes time to actually report the loss on your taxes, the exact location to enter the information is a bit ambiguous. It could fall under either miscellaneous deductions -- on Form 1040, Schedule A, for those who itemize -- or it could be an “other gain or loss.” While the IRS provides additional scrutiny of tax filings that report “other losses,” taxpayers might still want to report their annuity losses there because miscellaneous deductions are subject to an adjusted gross income reduction of 2 percent.
Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.