The Bonus That Isn't Free
Frank, 71, owns a nonqualified fixed deferred annuity he bought in 2015 for $180,000; it is now worth $250,000. He takes no withdrawals. Fourteen months remain on a surrender charge schedule, with about $7,500 of charge left. An agent proposes a 1035 exchange into an indexed annuity with a 10-year surrender schedule, a 10% premium bonus forfeitable for seven years, and a 2% annual income-rider fee. Frank wants reliable lifetime income beginning at 75 and wants to leave something for two grandchildren. He has $60,000 in bank deposits and Social Security of $2,300 a month. He asks, "Doesn't the bonus mean free money?"
1. If Frank simply surrenders the old contract, what are the tax results? Contrast that with the 1035 exchange.
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Surrender:
- Gain is taxed first (LIFO) on a nonqualified annuity: $250,000 − $180,000 = $70,000 of ordinary income. There is no capital-gain rate and no basis step-up for annuities.
- The 10% early-withdrawal penalty under IRC 72(q) applies only before age 59½, so no penalty at 71.
- The $7,500 surrender charge reduces what he receives and is not separately deductible.
- Illustration at a 24% federal bracket: $70,000 × 24% = $16,800 tax. Net: $250,000 − $7,500 − $16,800 = $225,700. Florida has no personal income tax, so state tax is zero.
1035 exchange:
- Under IRC 1035 the transfer is not currently taxable; the $180,000 basis carries over to the new contract, so the $70,000 gain remains embedded and is taxed whenever it comes out.
- Deferral is not forgiveness. If the new contract has higher fees, deferral can cost more than the tax saved.
2. Is the proposed exchange suitable for a 71-year-old who needs income at 75 and wants a legacy?
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Apply the facts against the proposal.
Against the exchange:
- A 10-year surrender schedule at age 71 runs to age 81. His only liquid assets are $60,000.
- He is 14 months from eliminating the existing $7,500 charge. Waiting costs nothing and removes a real cost.
- The 10% bonus is not free: it typically comes with lower caps or participation rates, a vesting schedule, and it is recovered first on withdrawal; it also enlarges the taxable gain if the contract is later surrendered.
- A 2% annual rider fee compounds against the contract for as long as he lives; the rider income must be compared with simply annuitizing the existing contract or buying a SPIA with part of the money.
- Legacy goal: a surrender-heavy, fee-heavy contract with a forfeitable bonus generally produces a worse death benefit than the existing contract plus a clean beneficiary designation.
Regulatory overlay: a replacement of an existing annuity triggers Florida's replacement requirements (notice regarding replacement, list of existing contracts, comparison, copy to the client, notification to the existing insurer) and the annuity suitability/best-interest standard. An exchange that resets a 10-year surrender period on a 71-year-old with near-term income needs is difficult to justify in the file.
Recommendation: do not exchange today. Wait out the 14 months, then compare the existing contract's income options against a SPIA or a partial exchange funded only with money he will not need. Document the alternatives considered, including "no action."
3. Frank dies after the exchange. What do the grandchildren owe, and how do free withdrawals interact with taxation?
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- No step-up in basis. Annuities do not receive a basis adjustment at death; the gain is income in respect of a decedent. The beneficiaries pay ordinary income tax on the gain as they receive it, using the decedent's $180,000 (or carried-over) basis. On a $250,000 value that is $70,000 of taxable income - plus any bonus or growth added.
- Any surrender charge is normally waived at death, but a non-vested bonus may reduce the value actually paid, so "$250,000 plus 10%" may not be what the grandchildren see.
- A spouse could elect to continue the contract and defer the tax; grandchildren cannot, and the payout period for non-spouse beneficiaries is limited.
- Free withdrawals: a typical 10% annual free-withdrawal provision avoids the surrender charge, not the tax. Because nonqualified annuity withdrawals are gain-first, a 10% withdrawal of $25,000 is fully taxable to Frank as long as $70,000 of gain remains. Clients routinely confuse "penalty-free" with "tax-free." Never present a free-withdrawal amount as a tax-free amount.