Are Surrender Charges Tax Deductible?

Annuities and insurance policies offer protection against hazards and risks to persons, property and investments. Holders of these instruments pay premiums to purchase and maintain financial hedges against future uncertainties.

In the case of annuities, the future is more certain, i.e., there will likely come a time when a person will need to stop working. While premiums convey revenue to those parties that issue annuities and policies, they also help to cover eventual claims in the future. Accordingly, financial institutions depend on regular payments from investors and policyholders. Should those remittances cease abruptly, the institutions may impose surrender charges.

What Are Surrender Charges?

A surrender charge, or fee, is exacted when an annuity or policyholder cancels or sells the instrument before a period of time, specified by the financial institution, elapses. A surrender period of this sort could be as short as a month or as long as a decade (or more). Most often, it tends to be on the longer side of that range.

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The purpose of this arrangement is not punitive toward the investor, but instead in the interest of financial stability. Salespeople and agents are often paid for a sale upfront before the company has made any profit, i.e., the policy issuer recoups its money only when sufficient funds have accumulated through premiums. If that accumulation is interrupted, the insurance company will suffer a loss. Then surrender charge mitigates that loss.

How Are Surrender Charges Deducted?

The surrender charge calculation depends in large part on the financial product in question. For example, surrender charges generally do not even apply to term life policies because zero dollars go back to the policyholder when the insurance policy is canceled.

Cash-value policies, on the other hand, may involve a large sum returning to the customer. The surrender charge is held back from that amount by the company, which calculates the fee as a percentage of the cash value of the policy. For annuities, the company may calculate against the amount withdrawn, gradually reducing the charge in the ensuing years.

Are Surrender Charges Tax Deductible?

The IRS, as a rule, prohibits deductions of surrender fees. Cashing out early on a life insurance policy or individual retirement account (IRA) is not viewed as an "ordinary and necessary" expense relative to these types of products. Fees that do fit this description are called "wrap fees" and are normally suitable for deduction from taxable income.

Moreover, they are paid with funds not generated by the annuity or policy. A perfect example is a trustee fee or payment to a financial planner to assist in the management of the annuity. These are not paid with proceeds but instead paid out of pocket. Thus, these can be deducted whereas surrender charges can not.

In April 2013, the Ninth Circuit Court of Appeals found for the plaintiff in Schwab and Kleinman v. Commissioner of Internal Revenue, declaring that the surrender fee associated with a life insurance policy erased the policy's value altogether and should therefore be deducted. While this opens the door of deduction potential for surrender fees, the IRS did not appeal the decision, so it holds only for the Ninth Circuit. This benefits those living in Alaska, Arizona, California, Guam and Hawaii.

Can You Avoid Surrender Charges?

Certain annuities have no-surrender features yet charge higher annual fees for the buyer. Still, waiting out the surrender period guarantees no extra expense. However, when shopping for annuities, you should realize that most do have surrender charges, and that's just part of the game.