IAM 60 years old. I invested $80,000 in an American Skandia variable annuity in December 2002.
In late January of this year, I received an IRS Form 1099-R that treated this annuity's $1,645 "administration fee" as a taxable event for 2003. How can this be? Administration fees extracted from IRAs and other tax-deferred investments are not treated as taxable income. Why are variable annuities different? And is there any way I can deduct this fee or mitigate its tax consequences?
-- W.D., Glastonbury, Conn.
Variable annuities look like mutual funds. They behave like mutual funds tucked inside an IRA. They are even sold as baskets of mutual funds, with life insurance features.
But a variable annuity -- especially when held outside an IRA or 401(k) plan -- is governed by the muddy language within a solitary contract. And that contract, for those who fail to read and comprehend its every word, can be riddled with surprises.
There are also surprises that take place outside the boundaries of the annuity contract. They involve quirks in federal tax laws.
They perhaps involve a financial adviser who did not clearly explain all the costs and tax consequences of buying, holding and hiring a manager for an $80,000 variable annuity contract.
Let's review how you probably set foot in this dungeon and how you might escape.
Your story begins on the day you purchased your $80,000 variable annuity from your financial adviser. It appears you granted your adviser the power to manage this account. Your adviser, in exchange for the responsibility of managing this investment, agreed to take a yearly fee that roughly equaled 2 percent of the assets under management ($80,000).
That fee was not paid in cash out of pocket. And that fee was not subtracted from the account on the date it first opened in 2002. That management fee, instead, was withdrawn sometime in 2003.
And, based on Internal Revenue Service rules, when advisers withdraw fees from an annuity account on dates after that account first opened, that withdrawal might be taxed as regular income, said Nicholas S. Scata, a certified public accountant with Saslow Lufkin & Buggy LLP in Avon, Conn.
Despite this apparent legal setback on one front, your $1,645 fee might not be treated as taxable income.
"Annuity withdrawals are taxed on an 'income first, premium second' basis," Scata said. So, if your $80,000 variable annuity in 2003 fell to, say, $76,000 (or even stayed put at $80,000), the fee paid to your adviser would be "treated as withdrawal of premium" and not taxed as regular income, Scata said.
If, on the other hand, your variable annuity appreciated by more than 2 percent in 2003, then that $1,645 fee -- treated as a withdrawal from the annuity -- would be taxed as regular income, Scata said.
To reduce the pain of a probable tax, you might try declaring this $1,645 fee as a "miscellaneous expense" (See line 22, Schedule A). But, to claim this tax break, you must itemize your deductions. And, only the portion of those expenses that exceed 2 percent of your adjusted gross income (See Form 1040, line 35), or AGI, may be fully deductible.
Example: Your AGI was $50,000 in 2003. If you had $1,645 in miscellaneous deductions, the first $1,000 would be lost to satisfy the 2 percent of AGI requirement. The remaining $645 could be deducted.
To learn more, visit the www.irs.gov Web site and download publications Nos. 575 and 939.
I know that every dollar withdrawn from an IRA is taxed as regular income, if that IRA was funded with contributions deducted in previous years. I also know that soon after I turn 70 1/2 , the law requires me to take annual withdrawals from my IRA. Now, what if -- to satisfy my required annual minimum IRA withdrawals -- I transferred 300 shares of stock from my tax-deferred IRA to my regular taxable brokerage account. How would I compute the "cost basis" for shares originally purchased inside an IRA but later transferred to a taxable account?
-- H.E.C., Wethersfield, Conn.
Shares moved directly from an IRA to a taxable account take on the cost basis that existed on the "date of transfer."
Example: You paid a split-adjusted price of $3 a share to buy 300 shares of Pfizer Inc. in 1989. In December 2003, you transferred those 300 shares from your tax-deferred IRA to your taxable brokerage account. Your brokerage statement claims those 300 shares, on the date you made this IRA-to-taxable-account transfer, were worth $10,200. The cost basis for that stock would therefore amount to $34 a share, or $10,200 divided by 300, said Dianne Besunder, a spokeswoman for the IRS in New York.
Matthew Lubanko is a financial columnist for the Hartford Courant, a Tribune Publishing newspaper. E-mail him at yourmoney@tribune. com.