The $310,000 Exchange Harold Wants Yesterday
Harold, 71, owns a nonqualified deferred annuity bought in 2021 with a $250,000 single premium; the accumulated value is now $310,000. The contract allows a 10% free withdrawal each year and carries a seven-year surrender charge that starts at 8% and drops one point per year. He is in the fourth contract year. A producer is urging him to 1035-exchange the entire balance into a new annuity with a 10-year surrender schedule and a 1.25% annual income-rider fee, projecting $28,000 a year of lifetime income beginning at 75. Harold has $40,000 in savings and a pension that covers his expenses. He says: "Take the whole $310,000 - the exchange isn't taxable, so the move costs me nothing."
1. Compute the real cost of moving the full balance, and describe a lower-cost approach.
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Harold is confusing tax with cost. The exchange is tax-deferred; it is not free.
Cost of a full move today (year 4, 5% charge remaining):
- Free withdrawal: 10% of $310,000 = $31,000, no surrender charge.
- Amount subject to charge: $310,000 − $31,000 = $279,000.
- Surrender charge: $279,000 × 5% = $13,950 (about 4.5% of the account).
- Plus the new contract restarts a 10-year surrender schedule, locking up money until Harold is 81.
Lower-cost sequencing:
- Take the $31,000 free withdrawal now (note the tax consequence, below) and leave the balance in place.
- Repeat the 10% free withdrawal in each remaining surrender-charge year, or simply wait until year 8, when the charge is zero, and move whatever is left.
- If the income rider is genuinely needed, buy it on the existing contract if available, or move only a portion - never the full $310,000 into a 10-year schedule.
The $13,950 is real money that buys Harold nothing except a new set of restrictions.
2. Is the 1035 exchange taxable? What are the tax consequences of the withdrawal and of the exchange?
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The exchange itself. A 1035 exchange of an annuity for an annuity is tax-deferred, and Harold's $250,000 basis carries over to the new contract. The $60,000 of gain is not forgiven - it is simply still inside the contract, waiting to be taxed later.
The withdrawal. Nonqualified annuity withdrawals are taxed gain first (LIFO). Harold's entire $31,000 free withdrawal comes out of the $60,000 of accumulated gain, so all $31,000 is ordinary income in the year taken. There is no basis recovery until the full $60,000 of gain has been withdrawn. If he is over 59½ - he is - the 10% early-distribution penalty does not apply.
Sequencing note. If he withdraws the free 10% and then moves the balance, he has accelerated $31,000 of ordinary income for no planning benefit. If his goal is simply to reposition assets, the better order is to reduce the surrender charge first and defer the taxable withdrawal to a year when his bracket is lower.
Harold should also be told plainly: the projected $28,000 of income at 75 is a projection based on a roll-up rate and the rider's payout rules, not a guarantee of that dollar amount, and the 1.25% rider fee is charged against the contract every year.
3. Assess suitability. What must the producer gather, and what red flags exist?
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Annuity sales - especially replacements to buyers over 65 - require a documented suitability review, not a suitability conclusion.
Gather and document: age, annual income and sources, liquid net worth outside the annuity, financial objective and time horizon, existing coverage and annuities, risk tolerance, whether the client understands surrender charges and the rider fee, and the specific reason the existing contract no longer fits. On a replacement, the producer must compare the old and new contracts in writing and give the required disclosure and free-look explanation.
Red flags in this file:
- Liquidity. $40,000 of savings plus a pension is thin for a 71-year-old to lock into a 10-year surrender schedule ending at 81.
- Duration mismatch. Harold is trading a contract with three years of exposure for one with ten.
- Cost stacking. $13,950 of surrender charge plus 1.25% annually for a rider he may not need, since the pension already covers expenses.
- Illustrated income framed as a promise. $28,000 at 75 depends on assumptions the client does not control.
- Twisting risk. The stated rationale ("the exchange is free") is factually wrong, which suggests the client does not understand the transaction.
If Harold still wants to proceed after a documented discussion, sell the smaller, shorter-surrender solution he actually needs. The free-look period exists to catch exactly this kind of sale, so the producer should assume the client will read the contract in detail.