Variable annuities are retirement investment accounts that also function like a life insurance policy. Investors can add risky investments to a variable annuity, which in turn means these accounts can lose money. Like other retirement plans, early withdrawals from variable annuities are discouraged through taxes and fees. However, investors who withdraw early on an account that has posted losses are able to claim tax deductions on those losses.
Investors buy variable annuities because they provide a consistent, annual payout upon retirement. A variable annuity doesn’t offer the same tax benefits as other retirement accounts, such as the 401(k) and Individual Retirement Account, which let investors defer taxes until retirement on the investment returns that the accounts generate. The difference is that variable annuity investment returns are taxed as income while 401(k)s and IRAs are subject to the lower capital gains tax. Because of these tax differences, along with the fees common to variable annuity accounts, the Securities and Exchange Commission recommends investors carefully explore the benefits of other retirement accounts before buying a variable annuity.
As with other retirement accounts, any early withdrawal can be costly for account holders. Any withdrawal from a variable annuity before the retirement age of 59 ½ triggers a 10 percent federal tax penalty. Not only that, but variable annuity accounts have “surrender periods” after purchase that can span from six to 10 years. Any withdrawal from the account during this period will result in surrender charges, which can be as high as 7 percent of the withdrawal amount, in addition to the 10 percent tax.
Unlike fixed annuities, which are designed around low-risk investments and offer guaranteed returns, variable annuities let investors choose among “sub-accounts” that work like mutual funds, offering different levels of risk or targeting different markets or industry sectors. The result is that a variable annuity can result in losses. However, unlike losses on stocks, options and other securities, money lost on annuity losses can't be deducted as investment losses in tax filings, preventing investors from using annuity losses to cancel out capital gains taxes on earnings from other investments such as stocks.
Variable annuity losses can be deducted from federal income taxes, although there is some debate about how to claim and classify these losses. The losses can be claimed as “miscellaneous deductions,” the total of which must be subtracted by 2 percent of the tax filer’s adjusted gross income. The IRS website says tax filers can claim miscellaneous deductions by using Schedule A. Any taxpayer that qualifies for the Alternative Minimum Tax can’t claim miscellaneous deductions. Another option is to claim losses on the variable annuity as “other gains or losses” on line 14 of IRS Form 1040. These losses aren’t subject to the AMT restrictions or the 2 percent AGI reduction that miscellaneous deductions require. However, according to the Rogers & Associates website, there is confusion about whether the IRS will recognize variable annuity losses as “other gains or losses." Claiming this deduction could trigger an IRS review of the tax filing.
Terry Lane has been a journalist and writer since 1997. He has both covered, and worked for, members of Congress and has helped legislators and executives publish op-eds in the “Wall Street Journal,” “National Journal” and “Politico." He earned a Bachelor of Science in journalism from the University of Florida.