Annuity Withdrawal, Surrender Charges, and a Bonus Exchange
Ruth, age 68, owns a nonqualified fixed deferred annuity with an account value of $300,000 and a cost basis of $200,000. Her contract allows a 10% free withdrawal each year; the surrender charge is 7% in contract year one and declines by 1% per year, so she is now in year three with a 5% charge. She wants $60,000 for a roof replacement and is also being pitched a 1035 exchange into a new annuity that offers an 8% premium bonus and a fresh 10-year surrender schedule. Ruth is in the 24% federal marginal bracket and has no state income tax. She does not need the money for income; this is a one-time expense.
1. Calculate the surrender charge and the amount of the $60,000 withdrawal that is taxable.
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- Free withdrawal: 10% × $300,000 = $30,000, with no surrender charge.
- Remaining withdrawal subject to surrender charge: $60,000 − $30,000 = $30,000.
- Surrender charge: 5% × $30,000 = $1,500.
- Net cash before tax: $60,000 − $1,500 = $58,500.
Taxation: nonqualified annuity withdrawals are taxed LIFO - gain first. Gain = $300,000 − $200,000 = $100,000. Since the $60,000 withdrawal is less than the $100,000 gain, the entire $60,000 is taxable as ordinary income. The 10% federal penalty does not apply because Ruth is over age 59½. At a 24% bracket, federal tax is $14,400, leaving about $44,100 after tax before withholding.
2. Evaluate the proposed 1035 exchange.
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A 1035 exchange can preserve tax deferral and carryover basis, and the 8% bonus is generally not taxed when credited - it increases the annuity's gain and is taxed later when withdrawn. But the exchange is questionable here:
- It starts a new 10-year surrender schedule, so Ruth's liquidity problem gets worse, not better.
- The bonus is often offset by lower caps, higher fees, or vesting requirements.
- Ruth does not need lifetime income; she needs a one-time $60,000 expense.
A better approach may be to take the free withdrawal amount and/or a partial withdrawal from the existing contract, or split withdrawals over two years, rather than lock into a new surrender period.