A 58-year-old client invested $100,000 in a variable annuity that is now worth $75,000. If the client surrenders the contract (no surrender charge applies), what are the tax consequences?

AThe client receives $75,000 tax-free since there is a loss
BThe client owes ordinary income tax on $75,000
CThe client may deduct the $25,000 loss as an ordinary loss on their tax return✓ Correct answer
DThe client owes capital gains tax on $75,000 plus a 10% penalty

Explanation

Why C — The client may deduct the $25,000 loss as an ordinary loss on their tax return

When a non-qualified variable annuity is surrendered at a loss (contract value $75,000 is less than cost basis $100,000), the investor may claim the $25,000 loss as an ordinary (miscellaneous itemized) deduction. There is no taxable gain since the contract value is below the cost basis. The 10% early withdrawal penalty applies only to earnings, and there are no earnings in this scenario.

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