A Tax-Free Exchange That Costs Her the Money She Needs
Ruth is 79, a widow with $1,900 a month in Social Security and about $40,000 in a savings account. Seven years ago she put $310,000 into a fixed deferred annuity that is now past its surrender-charge period, has a $200,000 cost basis, and is crediting 4.1%. She needs $1,800 a month of additional income starting now. Her agent proposes a Section 1035 exchange into a fixed indexed annuity with a 10-year surrender schedule (9% declining), a 10% annual free withdrawal, an 8% cap, and a guaranteed lifetime withdrawal rider that would pay $1,650 a month only if she starts withdrawals in five years. He tells her the exchange is "tax-free, so there's no cost."
1. Evaluate the suitability of the proposed exchange for Ruth.
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It fails on income timing and liquidity. Ruth needs $1,800 a month now; the rider pays nothing until she is 84, and the only path to $1,800 a month is a 10% free withdrawal of about $31,000 a year ($2,583 a month) that returns nothing and simply spends down principal while she is locked into a surrender charge that begins at 9% and does not expire until she is 89. She would trade a liquid contract with no surrender charge for illiquidity at exactly the moment she needs cash.
The "no cost" statement is wrong. A new surrender schedule, a possible market value adjustment, rider fees in the range of 1% a year, and the loss of a 4.1% crediting rate are all costs. Under the NAIC best-interest/suitability standard, the agent must have a reasonable basis tied to her income need, time horizon, and liquidity, and this file would be hard to document. Defensible alternatives: keep the existing contract and take systematic withdrawals, annuitize part of it, or buy a single premium immediate annuity with a portion of the $310,000 and keep the rest liquid.
2. How is Ruth actually taxed under the exchange, under withdrawals, and under annuitization?
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The 1035 exchange itself recognizes no gain, and her $200,000 basis carries over to the new contract. That is the only sense in which it is free.
Withdrawals from a deferred annuity are taxed LIFO - gain first - so roughly $110,000 of the $310,000 is gain. A $31,000 annual free withdrawal would be fully taxable until that gain is exhausted, at ordinary income rates. No 10% early-withdrawal penalty applies because she is past 59½.
Annuitizing is different: it creates an exclusion ratio, investment in the contract divided by expected return. If her expected return were $288,000, the ratio would be 200,000 / 288,000 = 69.4%, so of each $2,000 payment about $1,389 would be excluded from income and $611 taxed. Once her $200,000 basis has been recovered, the entire payment becomes taxable. The exchange does not improve either calculation - it only preserves basis.
3. If Ruth has already signed the application, what should she do now?
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If the contract has been delivered and she is still inside the free-look period, she should return it and take a full refund of premium - Georgia gives annuity buyers a free-look right (generally 10 days), and replacement transactions carry their own notice and refund requirements. That is the clean exit and it should be done in writing, with a copy retained.
If the free look has expired, she should take only the 10% free withdrawal, put the rest on hold, and complain in writing to the replacing insurer - flagging the suitability failure and the false "no cost" representation - and to the Georgia Department of Insurance. Insurers have a supervisory obligation over the producers they appoint, and suitability complaints sometimes produce a voluntary unwind. She should not count on surrender-charge waivers for annuitization or confinement, though those provisions may exist. The file should be judged on her income need and liquidity, not on the tax-free label.