1035 Exchange to an Indexed Annuity With a Lifetime Withdrawal Rider
Diane, 68, is widowed and in good health. In 2016 she invested $300,000 in a nonqualified fixed deferred annuity now worth $420,000. The contract has a 3% surrender charge with two years remaining and a 10% annual free-withdrawal provision. She also has a $180,000 IRA CD maturing next month, a $2,100 monthly pension, $1,900 monthly Social Security, and $25,000 cash. She wants $2,500 per month of guaranteed lifetime income beginning next year and wants to leave something to two grandchildren. A producer proposes a 1035 exchange into an indexed annuity with a 7% premium bonus, a 10-year surrender schedule, a 1.25% annual rider fee, and a guaranteed lifetime withdrawal benefit of 5% of an income base that grows 6% simple. Diane asks whether the exchange is in her interest.
1. Evaluate the proposed 1035 exchange. Include the surrender charge, the income math, and the liquidity and legacy consequences.
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The 3% surrender charge on $420,000 is $12,600, so a full exchange would transfer about $407,400; if she first takes the 10% free withdrawal of $42,000, the exchange would be about $378,000. The 7% bonus on $378,000 is $26,460, producing a $404,460 income base. A 5% withdrawal is $20,223 per year, or about $1,685 per month, not $2,500. Even if the base grows 6% simple for one year before withdrawals, $428,728 times 5% is $21,436 per year, or about $1,786 per month. The proposal misses her income target by roughly $714 per month. The bonus is not free: it is commonly paired with lower caps or participation rates, a long surrender schedule, and vesting or recapture provisions. The income base is not a lump-sum cash value and is generally not what beneficiaries receive. The 10-year surrender schedule also conflicts with a 68-year-old's need for liquidity, possible long-term care costs, and the stated goal of leaving a legacy. The 1.25% rider fee further reduces account value. Recommendation: do not exchange on these terms; request annuitization and withdrawal quotes from the existing contract first.
2. Compare the tax treatment of the free withdrawal, surrender, annuitization, and 1035 exchange, and explain how the grandchildren would be taxed.
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Diane's basis is $300,000 and the gain is $120,000. Nonqualified annuity withdrawals are taxed last-in, first-out, so the $42,000 free withdrawal is taxable gain until the $120,000 is exhausted; at 68 there is no 10% early-distribution penalty. A full surrender would produce $120,000 of ordinary income. A 1035 exchange is tax-free, carries over the $300,000 basis, and preserves deferral, but it does not avoid the surrender charge. Annuitization uses an exclusion ratio: each payment is partly return of basis and partly taxable until the $300,000 basis is recovered; if she dies before recovering basis, the unrecovered amount is deductible on the final return. At death, the annuity is income in respect of a decedent, so the grandchildren get no step-up in basis and pay ordinary income as they receive distributions. For a nonqualified annuity, IRC Section 72(s) generally requires the beneficiary to take the death benefit within five years or annuitize over life expectancy; the SECURE Act 10-year rule applies to IRAs, not to nonqualified annuities. Life insurance or taxable assets with a step-up would be more tax-efficient for the legacy goal.
3. What recommendation would you make to meet the $2,500 monthly goal while preserving some legacy?
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She needs $30,000 per year. Start with the existing annuity: request quotes for a life-only, life with 10-year certain, and cash-refund annuitization. If the contract waives surrender charges on annuitization, $420,000 at roughly 6.5% to 7.0% could produce $27,300 to $29,400 per year, close to the target. Use part of the $180,000 IRA CD, or a small immediate annuity purchased with part of it, to cover the shortfall and inflation. For example, annuitizing $250,000 of the existing contract and using $100,000 of the CD for a separate immediate annuity could produce the $30,000 target while leaving about $170,000 of annuity value and $80,000 of CD for liquidity and legacy. A life-only payout maximizes income but leaves nothing; a cash-refund or 10-year-certain payout reduces income but protects the grandchildren. Keep the $25,000 cash as an emergency reserve. Do not lock the entire $420,000 into a new 10-year surrender product to chase a bonus that does not meet the income need.