A Widow, a 1035 Exchange, and a Ten-Year Surrender Schedule
Eleanor, 68, receives $180,000 as beneficiary of her late husband's life insurance policy. She already owns a fixed deferred annuity with a current value of $150,000 and a cost basis of $120,000. It sits in year nine of a ten-year surrender charge schedule, with a 2% charge remaining. Her agent proposes a 1035 exchange into an indexed annuity with an 8% cap, a 0% floor, a 1.25% annual fee for a guaranteed lifetime withdrawal benefit featuring a 6% simple roll-up, and a fresh ten-year surrender schedule beginning at 9%. Eleanor needs roughly $900 a month of dependable income starting at age 71 and also wants to leave something for her grandchildren. She has $40,000 in savings and no other retirement assets.
1. Is the proposed exchange suitable, and what must the agent be able to document?
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The recommendation is hard to defend on these facts. The exchange restarts a ten-year surrender schedule at 9%, adds a 1.25% annual rider fee, and converts a contract that has almost fully amortized its charges into one that is illiquid for a decade. Eleanor is 68, needs income in three years, and has only $40,000 of outside liquidity.
Points the file must address:
- Cost of the move: 2% surrender on the existing contract (about $3,000) plus a new schedule that would penalize withdrawals exactly when she needs them.
- Benefit reality: the 6% roll-up is a simple interest figure applied to a benefit base; it is not cash value and is not available as a lump sum. At 0% floor with an 8% cap, credited interest may lag the fixed contract she already owns.
- Alternatives: keep the existing contract and annuitize or take free withdrawals at 71; use savings as a bridge; split the money between a liquidity sleeve and an income product.
- Process: signed replacement disclosure, illustration of the guaranteed income stream versus the existing contract, reasonable-basis suitability documentation under the annuity suitability/best-interest standard, and the client's free-look right on the new contract.
If the agent cannot articulate why the exchange beats keeping the paid-down contract, the recommendation fails.
2. Eleanor instead keeps the existing contract and annuitizes it for $950 a month with a 20-year period certain. What portion of each payment is taxable?
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Use the exclusion ratio: investment in the contract divided by expected return.
- Investment in the contract (basis, including any 1035 carryover): $120,000
- Expected return: $950 × 12 months × 20 years = $228,000
- Exclusion ratio: $120,000 ÷ $228,000 = 0.526, or 52.6%
Each monthly payment:
- Excluded (return of basis, tax-free): $950 × 0.526 ≈ $500
- Included in gross income: $450
Duration: the exclusion applies until her basis is fully recovered. Because the contract guarantees payments for 20 years, the basis is recovered inside the certain period, and every payment after that point is 100% taxable.
Cross-check: $500 × 12 × 20 = $120,000, exactly the basis. If she dies before the certain period ends, the remaining guaranteed payments pass to her beneficiary, taxable as income in respect of a decedent except for any unrecovered basis.
3. If Eleanor dies after receiving 36 monthly payments under that annuitization, what are the tax consequences, and how would the answer differ had she taken the indexed annuity instead?
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Under annuitization: basis recovered is $500 × 36 = $18,000, leaving $102,000 of unrecovered investment. That unrecovered amount is deductible on her final income tax return. The remaining 204 guaranteed payments continue to her beneficiary, taxable to the beneficiary as income in respect of a decedent, with the exclusion ratio no longer applying to the extent basis has been claimed on the final return.
Under the indexed annuity with the lifetime withdrawal rider: the contract is not annuitized, so there is no exclusion ratio. Gain is measured against total basis ($120,000 after the 1035 exchange) and every withdrawal is taxed last-in, first-out - fully taxable as ordinary income until cumulative withdrawals exceed basis. At death, the beneficiary receives the remaining value (or the greater of the contract value or benefit base, per the rider) and includes the excess over basis as ordinary income; the beneficiary may spread it over five years or take it as a lump sum.
The planning difference: annuitization produces a predictable tax-free slice; deferred withdrawal produces back-loaded taxation and no step-up.