Can I Deduct a Surrender Charge on an Annuity?

You might be able to get a tax benefit from a surrender charge.

You might be able to get a tax benefit from a surrender charge.

An annuity contract gives you a way to receive a steady stream of cash payments for a set period or for the rest of your life. You purchase an annuity contract by paying one or more premiums to the annuity provider, an insurance company. Your premiums and any income they earn determine how much you’ll receive in the annuity. You can surrender an annuity, but it might be costly.

Inside an Annuity

You start receiving payments on the annuity date. In a deferred annuity, you build up the cash value of your annuity through contributions to the contract. Contributions to a fixed annuity earn a set interest rate. Contributions to a variable annuity can be invested in mutual funds and other property. On the annuity date, the insurance company grabs your cash value and begins making payments. You can short-circuit the process by surrendering the contract before the annuity date.

Surrender Charges

Most annuity providers tack on hefty charges if you surrender the contract. The amount might decrease over time and disappear after a set number of years. When you surrender the annuity, you’ll receive the current cash value minus the surrender charge. If your annuity is qualified, you can’t deduct the surrender charge or recognize the loss. Qualified annuities reside in individual retirement accounts and employer plans. You might be able to take a loss on the surrender of a non-qualified annuity.

Non-Qualified Annuity Surrender

The gain or loss on a surrendered non-qualified annuity is equal to the surrender amount minus the cost basis. The surrender amount is the annuity’s cash value minus the surrender charge. The cost basis is the amount you contributed by way of premiums. Gains are taxed as ordinary income, not capital gains. Losses are also ordinary. Report your loss in Part II of Internal Revenue Service Form 4797. You can use the loss on the surrender of a non-qualified annuity to offset ordinary income but you can’t use it to reduce capital gains.

Qualified Annuity Surrender

You don’t shell out taxes on investments held in employer plans or IRAs until you take the money out. You also don’t get to deduct losses or fees, including surrender charges. However, you can empty out your IRA and take a loss if the distribution is less than the cost basis. Unfortunately, traditional IRAs seldom have any cost basis, but Roth IRAs do. Roth contributions are after-tax and create the account’s cost basis. If you surrender an annuity held in a Roth IRA, you can distribute everything in your Roth IRAs and take a tax deduction on the difference between the cost basis and the distribution. Claim the loss on Schedule A of Form 1040, subject to a miscellaneous deduction exclusion of 2 percent of your gross income.

 

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