Rosalind's $30,000 Roof: Withdraw, Exchange, or Annuitize?
Rosalind, 71, bought a nonqualified deferred annuity 12 years ago with a single $90,000 deposit. The contract is now worth $150,000. It has a 7-year surrender charge schedule that has fully expired, a 10% annual free-withdrawal provision, and no market value adjustment. She needs about $30,000 for a new roof. Her broker suggests instead exchanging the contract under IRC Section 1035 into a new annuity that pays a 7% first-year bonus and carries a fresh 10-year surrender schedule, and then withdrawing the $30,000 from the new contract next month. Rosalind is in the 24% federal bracket; assume her Hawaii marginal rate on this income is 8.25%. She has no other income needs and a life expectancy of roughly 15 years.
1. If Rosalind simply withdraws $30,000 from her current contract, how much is taxable and what is the tax?
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Withdrawals from a nonqualified annuity are taxed LIFO - earnings first.
- Contract value $150,000 − basis $90,000 = $60,000 of untaxed gain.
- The $60,000 gain exceeds the $30,000 withdrawal, so the entire $30,000 is ordinary income and none of it is a return of basis. Her basis stays at $90,000.
- No 10% federal penalty: she is over 59½.
Tax: 24% federal = $7,200; 8.25% Hawaii = $2,475; total $9,675, netting her $20,325.
Surrender charges: the schedule has expired, so exceeding the 10% free-withdrawal amount ($15,000) costs nothing in charges - a detail worth confirming in writing before she signs anything.
2. Evaluate the broker's 1035 exchange proposal. Does it help Rosalind?
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It defers tax; it does not reduce it - and it buys costs she may not live long enough to amortize.
- A 1035 exchange preserves the $90,000 basis and the $60,000 of deferred gain. The gain follows her into the new contract and is taxed on the way out; the exchange is a deferral, not an elimination.
- The 7% bonus (about $9,450 on the exchanged value) is not free money: it is generally treated as part of contract value and is typically recouped through higher mortality-and-expense charges, longer surrender schedules, or both. Only a first-year withdrawal would trigger a taxable event on the gain - which is exactly what the broker proposes.
- Suitability is the real problem. She is 71 with roughly a 15-year life expectancy and is being asked to accept a 10-year surrender schedule to access $30,000 for a roof. If she needs money for a health event at 76, every dollar above the free-withdrawal amount is exposed to a charge.
- Hawaii suitability rules require the producer to have reasonable grounds for the recommendation based on the consumer's age, income, financial situation, and needs. Recommending a surrender-schedule reset to fund a one-time $30,000 expense fails that test on its face; the recommendation should be documented as unsuitable.
Better answer: take the withdrawal now, pay $9,675, keep the remaining contract liquid, and revisit whether any exchange makes sense after the roof is done and her liquidity needs are reassessed.
3. Suppose she instead annuitizes the full $150,000 under a life-with-10-year-period-certain option and dies in year 3. What happens to the payments and how are they taxed?
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The guarantee, not the life, drives the remaining payments.
- Because a 10-year period certain was elected, the insurer must complete 10 years of payments. After her death in year 3, the beneficiary receives payments for the remaining seven years.
- Those payments carry the same exclusion ratio that applied to Rosalind: the portion attributable to her $90,000 investment is excluded from income, and the balance is taxable to the beneficiary as ordinary income. Once the investment is fully recovered, the remaining payments are 100% taxable.
- If she had chosen life only, nothing would continue to the beneficiary after death - a striking contrast for a client who wants to leave something behind.
- If she had chosen life with a cash refund, the beneficiary would instead receive a lump sum equal to the unrecovered investment, which is generally not taxable.
Planning point: the period-certain feature buys a survivor guarantee at the cost of a smaller monthly payment. At 71 with no dependents relying on her income, the reduction may not be worth it - the question to ask is who the guarantee protects.