What happens if you invest in a variable annuity that drops in value? Is the loss deductible, since the annuity is a tax-deferred investment?
The loss is deductible, but it is not a capital loss, like selling a stock that dropped in value. The mechanics of deducting the loss are also a little trickier. In order to take the loss, the contract must be surrendered to the company that issued it. You can’t transfer it to another insurance company. The loss will be equal to the amount you paid for the annuity, less the amount received, excluding surrender charges. Surrender charges imposed by the insurance company are not a deductible loss.
The problem most people have at this point is how to report the loss. Since it is not a capital loss, it does not get reported on Schedule D. It is considered an ordinary loss, which means you can take the entire loss in one year. The deductible amount will not be capped at $3,000, unless you have other gains to offset it. The IRS reported in Revenue Ruling 61-201 that the loss in a single premium refund annuity contract was deductible as an ordinary loss.
There is some debate as to whether the loss should be reported as a miscellaneous deduction or listed under other gains/losses on the tax return. Claiming it as a miscellaneous deduction is the conservative approach. However, the loss will be subject to the 2% AGI floor and could cause problems for taxpayers subject to the alternative minimum tax (AMT). The aggressive approach would be to list the loss under other gains/losses. The IRS may flag it for a closer examination, and there’s no clear authority that the loss belongs on this line. However, if it’s classified this way it will be fully deductible (no 2% floor) and will not cause problems for AMT purposes.