A 1035 Exchange Out of a Living-Benefit Contract
Rosa, 68 and single, bought a nonqualified variable deferred annuity in 2011 with a $200,000 single premium. It is now worth $310,000. The contract carries a guaranteed lifetime withdrawal benefit: she may begin withdrawals at 70 of 5% of a $340,000 income base, about $17,000 a year, for life. She has taken no withdrawals and the original surrender charge has expired. A new agent proposes a 1035 exchange into a fixed indexed annuity with a 10% premium bonus, a new 10-year surrender schedule starting at 10%, a 6% simple roll-up on the income base, and a lower lifetime payout percentage. Rosa also has a $150,000 certificate of deposit maturing next month that she would like to add to whatever contract she keeps. She is still working part-time, earns about $70,000, and expects to file single. She wants income she cannot outlive and wants to leave whatever remains to her two adult children.
1. Evaluate the proposed 1035 exchange. What analysis would you do, what would you recommend, and what would you do with the maturing CD?
Read the worked answer
Compare the two contracts on the only numbers that matter: guaranteed lifetime income, total cost, and exit.
The old contract already guarantees $17,000 a year for life beginning at 70, on money held 14 years with no surrender charge left. The proposal's 10% bonus is real but is typically recovered through a lower payout percentage, a longer surrender period, and higher mortality and expense charges; the 6% roll-up applies to a bookkeeping income base, not to cash value Rosa can ever withdraw.
Put the two side by side: what would the new contract actually pay per year at 70, on a guaranteed basis, after all fees? If it pays more than $17,000, the exchange may be justified. If it pays less, the bonus is marketing. Also weigh the new 10-year surrender schedule - Rosa would be 78 before she could exit without penalty. Annuity exchanges are scrutinized under the NAIC best-interest model, so the suitability file should document the comparison in writing.
The CD is a separate decision. A multi-year guaranteed annuity or a short SPIA funded with $150,000, kept outside the exchange, preserves the old contract's living benefit and adds income without restarting a surrender period on her existing money.
2. Explain how withdrawals and annuitization would be taxed on this contract, and what happens to basis in a 1035 exchange.
Read the worked answer
Nonqualified annuity taxation follows a strict ordering rule. Before annuitization, every withdrawal is ordinary income until all $110,000 of gain is recovered; only then does basis come out. A $20,000 withdrawal this year would be fully taxable at roughly 22-24%, potentially plus the 3.8% net investment income tax, and it would count in MAGI for Medicare premium purposes two years later. The 10% early-withdrawal penalty does not apply because she is past 59½.
A 1035 exchange preserves the $200,000 basis. It does not create a step-up and does not reset cost basis.
Annuitizing changes the math. The exclusion ratio is investment in the contract divided by expected return. If she annuitized at 70 with $200,000 of basis and a carrier-projected total return of $400,000, the ratio would be 50%: half of each payment excluded from income until basis is fully recovered, then everything taxable. Annuitizing converts part of the gain into a partly tax-free stream; ad hoc withdrawals just accelerate it.
Two side notes: adding the CD to a brand-new contract does not create a MEC, but overfunding an existing flexible-premium contract beyond the 7-pay limit can; and annuity income counts in MAGI for IRMAA.
3. Rosa wants to leave what remains to her two adult children. Identify the death benefit, estate, and beneficiary issues she should address.
Read the worked answer
Because Rosa owns the contract, the full value is included in her gross estate under IRC 2039, and the $110,000 of untaxed gain is income in respect of a decedent - the children get no step-up and will pay income tax on that gain as they receive it.
If she dies before annuitizing, the contract's death benefit is paid to the beneficiaries. As non-spouse beneficiaries they cannot do a spousal continuation, and the SECURE Act ten-year rule generally requires the account to be emptied within ten years, which may push them into high brackets during peak earning years.
If she annuitizes with a life-only payout, nothing passes to the children - a real risk given her stated goal. She should insist on a life-with-period-certain or return-of-premium death benefit so the children receive something.
Practical steps: review the beneficiary designation now (a former spouse is the most common error on older contracts), confirm in writing the death benefit option before annuitizing, and consider naming a trust if she wants control over how and when the children spend the money.