Many variable annuity investors are in a pickle.   They've got major losses in a vehicle designed to defer taxes on gains.

Investors in taxable accounts can use losses in one investment to offset gains realized in another. If their losses exceed their gains, they can deduct $3,000 a year against ordinary income.

Variable annuity investors with losses may have to pay penalties to realize their losses. In addition, losses aren't realized in the same way as those in a taxable account.

This isn't a minor problem.

Of the 8,722 variable annuity sub-accounts with 3-year histories that invest in domestic equities, 8,042 lost money. Some 4,589 of the accounts did worse than the three-year annualized loss experienced by the Vanguard 500 Index fund, 16.14 percent.

Only pathetic vestiges of the original investment remain in some accounts. Fidelity Retirement Reserves PBHG Technology and Telecommunications, for instance, still has $127 million invested. But it has lost at an annual rate of 54.12 percent a year for the three years ending March 31, according to Morningstar. So $10,000 invested three years ago is now worth about $1,000, a 90 percent loss.

What to do?

There are two options. Sales people offer one. The other is less known because no one sells it.

Here's the sales option. You do a 1035 exchange to another variable annuity contract. You leave a portion of your money in the first contract so it is still in force. This leaves the insurance company on the hook for what remains of the death benefit. The exchange will avoid any federal penalties for withdrawal but it may incur early withdrawal penalties from the insurance company. Because some of the death benefit from the original contract is still in force, your loss is transmuted into a life insurance benefit.

The transaction will generate a hefty commission for the sales person. And, personally, I just hate it when I have to die to collect a benefit.

When you make this kind of transfer, you can't take a loss on your income taxes because it is a tax-free exchange. It also doesn't help you escape from an investment product that has punitively high expenses.

So let's examine the second option. It will require the help of a good tax accountant.

Robert Carlson, editor of the Retirement Watch newsletter, suggests cancellation of the variable annuity contract.

"You have to do the transaction so it does not qualify as a tax-free exchange," he comments. If the contract is terminated you can claim a loss under "Miscellaneous" deductions.

If you invested $100,000 three years ago, have withdrawn no money, and now have an account worth only $50,000, your loss would be $50,000. There would be no Federal penalty for withdrawal before age 59  ½ because you would have made no money. The early withdrawal penalty from the insurance company, however, would not be deductible as a loss--- but it would be smaller because your account is smaller.

If your adjusted gross income is, say, $75,000 and you are filing a joint return, you'd be in the 27 percent tax bracket. In addition, your "Miscellaneous" deductions must exceed 2 percent of your AGI to be deductible. So you'll only be able to deduct $48,500 ($50,000 less $1,500).

Even so, the deduction will cut your tax bill by $13,095--- provided it doesn't trigger the Alternative Minimum Tax. (Remember, you need a good tax accountant.)

Not bad.

Where do you invest the proceeds?

In a large no-commission, low-cost index fund with a large negative capital gain exposure. Recently, for instance, Morningstar data showed that the Vanguard 500 Index fund had a negative capital gain exposure of only 5 percent.

Similar funds with larger negative capital gain exposures would be better choices. Vanguard Total Stock Index, for instance, has a negative capital gain exposure of 29 percent. At a 20 percent tax rate that negative capital gain exposure represents a future saving of 5.8 percent of your investment (.20x.29).

Fidelity Spartan Total Market Index is similar--- it has a 26 percent negative capital gain exposure, a 5.2 percent future saving; Scudder Equity 500 Index has a 38 percent negative capital gain exposure, a 7.6 percent future saving, and Schwab S&P 500 e.Shares have a 32 percent figure, a 6.4 percent future saving.

Although all of these funds have taxable dividend payments (about 1.5 percent), none is likely to make a capital gain distribution in the near future.