An annuity contract allows you to exchange a sum of money for a stream of payments that can continue for the rest of your life. However, sometimes an annuity owner has a change of mind and decides to cash in the contract. The issuer, normally an insurance company, may charge a surrender fee when you cash out. These fees are not tax deductible
A “qualified” annuity resides in an individual retirement account or employer plan. An IRA shields income from current taxes, but it also shields expenses from tax deductions. Any expenses, including surrender charges, paid with IRA money are not deductible. However, the situation changes when you pay certain IRA charges, called “wrap fees,” with non-IRA money. Wrap accounts combine commissions and management fees into a flat monthly or quarterly charge. The Internal Revenue Service allows you to deduct IRA wrap fees with non-IRA money.
A deferred annuity starts in an accumulation phase in which you build its cash value. Your IRA contributions and the income they earn grow until the annuity date, at which point the issuer takes possession of the account balance and begins making payments. This is the distribution phase. You can surrender an annuity during the accumulation phase and receive your cash value minus any surrender charge. The annuity provider deducts the fee from your cash proceeds. Unless you roll the money into another IRA, the IRS will tax it. If you are younger than 59 1/2, the IRS might slap on a 10 percent penalty.
The IRS has ruled that IRA trustee fees are deductible. In a private letter ruling, the IRS extended this decision to allow you to deduct IRA expenses that were “ordinary and necessary” and paid with non-IRA money. The service subsequently affirmed that these payments are not contributions to an IRA. Surrender charges are not ordinary, however. They arise from a specific event and are therefore not a deductible IRA wrap fee. A wrap fee is a miscellaneous itemized expense. You can only deduct these to the extent they exceed 2 percent of your adjusted gross income.
You can deduct an IRA loss if you meet certain conditions. You must distribute the entire balance of the IRA to take the deduction. You can deduct the excess of the IRA’s cost basis over the distributed amount. An IRA’s cost basis is equal to the nondeductible contributions residing in the account. Traditional IRAs can have nondeductible contributions in years when you or your spouse belong to an employer pension plan and you have adjusted gross income exceeding set limits. All contributions to a Roth IRA are nondeductible. An IRA loss is subject to the 2 percent exclusion for miscellaneous deductions.