A 1035 Exchange, a Surrender Charge, and a Client Who Wants Income Now
Diane, 71, owns a nonqualified deferred annuity purchased six years ago: account value $320,000, cost basis $200,000, a surrender charge of 4% today that grades to zero in two years, and a market value adjustment. Her agent proposes a 1035 exchange into a new variable annuity carrying a seven-year surrender schedule, a 1.25% annual guaranteed lifetime withdrawal benefit rider, and a 1.00% MVA. Diane wants $2,000 a month of guaranteed lifetime income beginning now and is in good health. She also holds a $260,000 bank CD maturing in 60 days, a $90,000 inherited IRA she does not need, and a $25,000 emergency fund. She is in the 24% federal bracket and has no other retirement income beyond Social Security.
1. Evaluate the suitability of the proposed 1035 exchange and identify the alternatives the agent must consider.
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The immediate cost is real and not offset by tax deferral. A 4% surrender charge on $320,000 is $12,800, plus an unknown but likely four-figure MVA. Diane then starts a fresh seven-year surrender schedule that runs until she is 78 - precisely the years she is most likely to need liquidity for health or long-term care costs. Loaded on top are the 1.25% rider, subaccount expense ratios, and mortality and expense charges, so total annual drag may reach 2.5% to 3.5%, or $8,000 to $11,000 a year, to generate $24,000 of income.
Reasonably available alternatives the agent must document:
- Turn on income from the existing contract - annuitize or activate any existing withdrawal feature - with no surrender charge.
- Fund the new benefits with the maturing CD, which costs nothing to reposition, while leaving the low-basis contract alone.
- Buy a single premium immediate annuity with the CD money for the $2,000 monthly income, at a competitive payout at age 71.
Under the NAIC Suitability in Annuity Transactions Model Regulation (adopted in Illinois) and Reg BI, the agent must have a reasonable basis, weigh costs, and record why the exchange beats the alternatives. Paying $12,800 to buy a guarantee she may already own, and locking her up to 78, is difficult to justify. The defensible recommendation is to fund income from the CD.
2. Diane asks what happens if she simply withdraws $40,000 from the current contract. Show the tax result and contrast it with annuitizing.
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Withdrawal: gain comes out first. Nonqualified annuity withdrawals are taxed LIFO. The contract has $120,000 of gain ($320,000 value less $200,000 basis), so the entire $40,000 is ordinary income - taxed at 24%, about $9,600 - and none of it is a return of basis. Afterwards the value is $280,000, the basis is still $200,000, and the remaining gain is $80,000. There is no 10% premature distribution penalty because Diane is past 59 1/2. Capital gain rates do not apply to annuity gain, and annuity income is not subject to the 3.8% net investment income tax only because her modified AGI is below the threshold - that is a fact to verify, not assume. A policy loan from a non-MEC contract is tax-free, but a loan in excess of basis is taxable.
Annuitization: exclusion ratio. If she converts the contract to a life annuity, each payment is split by the exclusion ratio: investment in the contract divided by expected return. With a $200,000 basis and, say, a $400,000 expected return, 50% of every payment is excluded from income until her basis is fully recovered; after that, payments are 100% taxable. If she dies before recovering basis, the unrecovered amount is deductible on her final return.
For a client who wants $2,000 a month, the choice between LIFO withdrawals and annuitization is a choice between faster basis erosion and an irrevocable payout.
3. Diane asks the agent to 1035 the $90,000 inherited IRA into the same new annuity. What is wrong with that request?
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Section 1035 does not reach IRAs. A 1035 exchange applies only among life insurance contracts, endowment contracts, annuity contracts, and qualified long-term care contracts. Moving money out of an IRA into a nonqualified annuity is a distribution, not a tax-free exchange - the full $90,000 would be ordinary income, and since she is past 73, RMD rules apply.
Inherited IRA money has its own regime. It must stay in an inherited IRA titled for the decedent. It can be moved only by trustee-to-trustee transfer; a 60-day rollover is unavailable to a non-spouse beneficiary. Distributions follow the 10-year rule (or eligible designated beneficiary rules if she qualifies), and the funds cannot be commingled with her own nonqualified annuity. An annuity inside an inherited IRA is permissible as an investment, but the new surrender schedule could trap money that must be distributed within the 10-year window - a fatal mismatch.
What the agent should say: keep the inherited IRA where it is or move it to a low-cost inherited IRA, take required distributions on schedule, and never combine it with the nonqualified annuity purchase. Documenting this refusal is itself good suitability evidence.