Q Dear Rick:
I have a tax situation I hope you can help me with. In May of 2005 I bought an annuity. I had some cash from an inheritance and I invested $75,000. I’ve never taken anything out of the annuity and today it’s worth about $62,000. I recently sat down with a representative from the company who sold me the annuity and he told me that the only way that I could deduct my loss from the annuity is to transfer my old annuity into a new annuity. He said by doing it that way I would be able to deduct my loss. He told me that it was known as a 1035 transaction. A friend of mine told me that it is not true; that I can’t deduct my loss. Can you tell me who is right? I also have a separate IRA and was told that since I only have one IRA and the only money I have ever put into it was non-deductible IRA money, that I could convert that to a Roth and pays no taxes; is that right?
A Dear Gary:
Unfortunately, your annuity salesperson was wrong on both accounts. First, when it comes to your annuity, losses on annuities are not tax deductible. Therefore, whether you cashed out the annuity or transferred it into another annuity, the loss is not deductible. I think the annuity salesperson was selling you a bill of goods just to get you to buy another annuity. Whether he knew what he was telling you is wrong or he was just incompetent, it’s a sure sign that he is not someone you should be dealing with.
A 1035 exchange allows you to move money from one annuity to another annuity without tax consequences. It’s generally used where there’s a gain so that you can delay paying taxes on that gain. In your situation, a 1035 exchange may make sense because if you move the money into a new annuity you would have a transfer basis. Your basis is $75,000. Therefore, if you transferred the $62,000 and the annuity actually grew, the first $13,000 would virtually be tax free because that would just bring you back to your original basis. In that regard, the only type of annuity in this situation that I would recommend would be one that had very low cost and no backend penalties. Companies like Vanguard, Fidelity and Charles Schwab all offer no-load annuities without backend penalties. Once the annuity got back up to the $75,000 you could then cash it out and pay no taxes.
With regard to the Roth conversion, once again, your annuity salesperson was wrong. When you have a non-deductible IRA, you have a basis which is your original contribution. That amount is not taxed to you; however, all the earnings the money earned are taxed. For example, let’s say that you made $2,000 a year in non-tax deductible contributions for five years. Your basis in that IRA would then be $10,000 ($2,000 x 5 years). If the IRA is worth $15,000 and you convert it, you would have to pay taxes on the $5,000 ($15,000 – $10,000).
For those with non-deductible IRAs, converting is an excellent alternative. However, if you have both deductible and non-deductible IRAs, you can’t choose to just convert the non-deductible IRA. In those situations, you have to do a proration between deductible and non-deductible.
When it comes to taxes, our laws are constantly changing and they are complex. My advice is to be very leery about taking tax advice from anyone who’s trying to sell you a product.