Louise's 1035 Exchange and the 5% Roll-Up
Louise, 72, is a widow in Lafayette. Her husband's $250,000 life insurance benefit sits in a bank account earning almost nothing. She also owns a fixed deferred annuity bought in 2016 with a $150,000 single premium; it is now worth $190,000, is in year 8 of a 10-year surrender schedule with a 4% charge, and allows a 10% annual free withdrawal. She needs about $1,500 a month of dependable income, has no long-term care insurance, and had a minor stroke last year. Her agent recommends a 1035 exchange into a fixed indexed annuity with an 8-year surrender schedule, a 7% cap, a 1.25% annual guaranteed lifetime withdrawal benefit rider fee, and a 5% simple roll-up.
1. Run the numbers on the proposed exchange and give a best-interest recommendation.
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Cost of replacing: 4% × $190,000 = $7,600 surrendered today; about $182,400 transfers.
She does not need to pay it to get income. The 10% free withdrawal is $19,000 a year - more than the $18,000 her $1,500/month goal requires. She could fund her income entirely from free withdrawals and still have the $250,000 bank balance as a liquidity reserve.
What the new contract costs:
- 8-year surrender at age 72 - illiquid until 80, precisely when long-term care risk peaks, with no LTC coverage and a stroke history. That is the opposite of what her situation calls for.
- Rider fee: 1.25% × $190,000 = $2,375 a year, roughly $19,000 over eight years - before any surrender charge.
- Cap minus fee: 7% cap less 1.25% leaves about 5.75% net in good years; in flat years the fee still comes out.
- Roll-up realism: a 5% simple roll-up may never exceed the account value in strong markets, so the rider can add cost without adding benefit.
Break-even: $7,600 ÷ $182,400 ≈ 4.2% cumulative, about 0.5% a year for eight years, before fees. If the new contract only matches her current renewal rate, she never recovers the surrender charge.
Recommendation: the exchange is hard to justify. Alternatives to present - keep the existing contract and take free withdrawals; annuitize a portion of the $190,000 (or part of the bank balance) for guaranteed lifetime income with no rider fee; or use the bank funds first for LTC liquidity. If a replacement proceeds, the file must document the guaranteed values side by side, her objectives, and why the alternatives were rejected. Note that Louisiana gives her a free-look period after delivery to return the new contract for a full refund - that window is the last chance to unwind it.
2. How will her withdrawals be taxed, and how does a 1035 exchange change that?
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Withdrawals during accumulation are LIFO - gain first.
- Basis: $150,000. Value: $190,000. Gain: $40,000.
- A $19,000 free withdrawal is entirely ordinary income - none of it is a return of basis, because gain still exceeds the withdrawal.
- After the withdrawal: value $171,000, basis still $150,000, remaining gain $21,000.
- No 10% premature-distribution penalty - she is past 59½. But the income still counts toward taxable Social Security and toward IRMAA (Medicare premiums are set from the return filed two years earlier).
What a 1035 exchange does: it is tax-free and carries the $150,000 basis forward into the new contract. The $40,000 gain is not taxed now, but it is not forgiven either - the new contract's gain is measured from $150,000, so every future dollar above that is taxable income. There is no step-up.
If she annuitizes instead: the exclusion ratio (investment in the contract ÷ expected return) makes each payment part nontaxable return of basis and part taxable; once basis is fully recovered, payments are 100% taxable. If she dies before recovering basis, the unrecovered amount is deductible on her final return. Annuitizing changes both the tax pattern and the liquidity, which is why it must be modelled before it is signed.
3. If Louise dies, what does her daughter receive and what must she do?
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What she receives: at minimum the contract value; with a GLWB, typically the greater of the account value or the benefit base (the contract controls). The death benefit is ordinary income to the extent of gain - the $150,000 carryover basis is not stepped up, ever.
No spousal continuation. The daughter is a non-spouse designated beneficiary, so the SECURE Act rules apply. Because Louise died before the annuity start date, the daughter must fully distribute the account within 10 years; annual required distributions are not required, but the entire balance must be out by the end of year 10.
Her practical options:
- Lump sum - simple, but all the gain hits one tax year and can push her into a higher bracket and onto a higher Medicare premium.
- Spread withdrawals over the 10 years - usually the better answer for a large gain, but she loses the deferral benefit of waiting.
Alternatives that would have changed the outcome: had Louise added a joint-and-survivor annuitization option or a period-certain guarantee, the payment stream itself would continue to the daughter instead of a lump of account value. Had she named a spouse, that spouse could have stepped into the contract and continued deferral. The beneficiary designation and the payout election are the two decisions that determine what the daughter actually nets after tax.