Harold's Annuity: Withdrawals, a 1035 Exchange, and the Heirs' Tax Bill
Harold, 70, owns a nonqualified deferred annuity worth $300,000 with a $180,000 cost basis. Aside from Social Security he has no pension income, and he needs $40,000 a year for five years to cover a grandson's tuition. His agent presents three options: (1) take $40,000 annual withdrawals; (2) make a 1035 exchange into a new annuity offering a 2% premium bonus but an eight-year surrender charge schedule; or (3) annuitize the contract over ten years. Harold is in excellent health, expects to live into his nineties, and wants whatever remains to pass to his grandson.
1. How will the $40,000 annual withdrawals be taxed?
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Nonqualified annuity withdrawals are taxed LIFO - gain comes out first.
- Gain in the contract: $300,000 − $180,000 = $120,000.
- Years 1–3: each $40,000 withdrawal is 100% ordinary income. That exhausts all $120,000 of gain.
- Years 4–5: withdrawals come from the $180,000 basis and are tax-free.
- 10% penalty: inapplicable - Harold is past 59½.
- No capital-gain treatment: annuity gain is ordinary income, not long-term capital gain.
Contrast with option 3: annuitizing uses an exclusion ratio ($180,000 basis ÷ total expected return), so each payment is part return of basis and part taxable - a smoother tax profile, but it locks him into fixed payments and typically ends the death benefit at the end of the guarantee period. For a five-year need, LIFO withdrawals are simple but front-load the tax.
2. Evaluate the 1035 exchange into the bonus annuity.
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What works: a 1035 exchange from one annuity to another is permitted, so no gain is recognized and the $180,000 basis carries over. He keeps $120,000 of untaxed gain deferred.
What doesn't work for this client:
- Mismatch of horizons. He needs $40,000 a year starting now, but the new contract imposes surrender charges for eight years. He would be paying a penalty to reach his own money - exactly when he needs it.
- The bonus is not free. Premium bonuses are recovered through higher mortality and expense charges or longer surrender schedules. In year one the "2%" is far smaller than the surrender charge he would face on a partial withdrawal.
- It doesn't improve his tax position. The withdrawals would still be LIFO against the same $180,000 basis, so the exchange defers nothing he wasn't already deferring.
- Direction rules: annuity-to-annuity and annuity-to-LTC exchanges qualify under 1035; annuity-to-life-insurance does not. Anyone proposing that direction is proposing a taxable transaction.
Conclusion: the exchange is a sales-driven recommendation, not a planning one. Keeping the existing contract and withdrawing is the better fit.
3. Harold dies with $200,000 remaining and $60,000 of unrecovered basis. How is that value taxed to his grandson?
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The $140,000 of unrecognized gain ($200,000 − $60,000) is income in respect of a decedent (IRD).
- No step-up in basis. The general basis step-up at death does not apply to annuities; the heir inherits Harold's $60,000 basis, not the $200,000 value.
- Ordinary income. When the grandson withdraws, the gain is taxed to him at ordinary income rates. Whether he takes a lump sum or stretches payments, the character doesn't change.
- Planning implication: if Harold had annuitized, the unrecovered basis at death would be deductible by the beneficiary against the remaining guaranteed payments. By staying in deferral, he maximizes the amount passing to his grandson but also maximizes the embedded tax.
This is the practical argument for the grandson to take withdrawals over several tax years rather than a lump sum - the rate bracket, not the total, is what he can control.