The 7% Bonus, the 6% Surrender Charge, and a $40,000 Roof
Gwen, 68 and in good health, owns a nonqualified single-premium deferred annuity bought in 2019 when she made a 1035 exchange out of an older contract. The current value is $160,000; her basis, including the older contract's basis, is $100,000. The contract is in year 3 of a 7-year surrender charge schedule; the year-3 charge is 6% and the free-withdrawal allowance is 10% of contract value per year. Gwen wants to move the contract to a new annuity offering a 7% premium bonus, a 10-year declining surrender schedule, and a 10% free withdrawal, and she also needs $40,000 in cash within 60 days for a roof and a bathroom remodel. She asks whether the bonus 'makes the exchange a no-brainer' and whether taking the money before or after the exchange matters for taxes.
1. Compare the tax treatment of the $40,000 taken before versus after the exchange.
Read the worked answer
Identical either way - LIFO, ordinary income, no penalty.
- Gain = $160,000 value − $100,000 basis = $60,000. On a nonqualified annuity, withdrawals come out gain-first. The entire $40,000 is taxable as ordinary income.
- No 10% early-withdrawal penalty: she is past 59½, and the penalty would only reach the taxable portion anyway.
- A 1035 exchange changes none of this. The new contract inherits $100,000 of basis and $60,000 of unrealized gain, and the next withdrawal from the new contract is still gain-first. Anyone who tells her the exchange 'avoids' the tax is wrong - it defers tax she is not otherwise required to pay.
- If she later annuitizes, the $100,000 basis is recovered gradually through the exclusion ratio.
- Withholding: the carrier will default to federal withholding unless she elects out, so she should plan for the estimated tax rather than be surprised in April.
Bottom line: the tax is not the deciding variable. The surrender charges and the lock-up are.
2. Compute the surrender-charge cost of each sequencing and recommend a course of action.
Read the worked answer
Run the surrender-charge math before the bonus math.
Option A - take the $40,000 out of the existing contract first:
- 10% free = $16,000.
- Charge applies to the remaining $24,000 at 6% = $1,440.
Option B - exchange first, then withdraw:
- To the old carrier, an exchange is a withdrawal unless the contract waives charges on a 1035 exchange (some do inside a window; many do not). 6% × ($160,000 − $16,000 free) = $8,640 out of her pocket.
- Then the new contract's 10% free withdrawal is about $16,000, so $24,000 of the $40,000 hits a new, larger first-year charge - roughly 9% × $24,000 = $2,160 - on top of the $8,640.
What the bonus is really worth: 7% of $160,000 = $11,200, but bonuses almost always carry a vesting schedule (commonly 10% a year) and are frequently excluded from the free-withdrawal base. If she needs cash in years 1–3, she can forfeit part of it. The real comparison is $11,200 (partly contingent, locked up to age 78) against roughly $8,640–$10,800 of certain charges plus a fresh 10-year schedule.
Recommendation: stay put for now. Take $16,000 free this year, another $16,000 after the next anniversary, and the final $8,000 the year after - zero surrender charge, no new lock-up, and the old contract exits its schedule in four more years. Evaluate an exchange as a separate decision later, on its own merits. If she does exchange, use a direct trustee-to-trustee transfer, never a check payable to her.
Also complete the suitability comparison the replacement rules require: what is being replaced, what is being lost, and can the file document it.
3. If Gwen instead wants guaranteed lifetime income, how is that taxed, and is it the right move here?
Read the worked answer
Exclusion ratio - then a hard look at whether annuitizing makes sense at all.
- Annuitizing a nonqualified contract: expected return = annual payment × the IRS multiple for her age (Table V gives roughly 17–18 years at age 68; verify the current table). Exclusion ratio = $100,000 ÷ expected return. That fraction of each payment is tax-free return of basis; the rest is ordinary income. Once the full $100,000 has been recovered, every dollar is taxable. If she dies before recovering basis, the unrecovered amount is deductible on her final return.
- Whether she should: probably not now. Annuitization is irrevocable, she has a $40,000 liquidity need in the next 60 days, and she would be converting an asset she controls into a stream she cannot access or leave to heirs - unless she buys a period-certain or cash-refund option, which lowers the payment.
- Alternatives that meet the same need: systematic withdrawals from the existing contract (taxed LIFO but flexible), or a deferred income annuity purchased now with income starting at 75–80, which keeps the money invested and the death benefit alive.
- If her health were impaired, annuitization would be a particularly poor deal: a life-only annuity pays nothing to the estate and retail contracts generally offer no impaired-risk adjustment.
- Operational note: many contracts allow annuitization without a surrender charge after a set number of years; if she is close to that point, waiting can be worth more than any bonus.