A 1035 Exchange Recommendation for a 76-Year-Old With a Liquidity Need

Option A - free withdrawal from the existing contract.

• Free amount is 10% of accumulated value ($26,800) or 10% of purchase payments ($25,000), depending on how the contract defines it; the contract language controls.
• Withdrawing $35,000 means roughly $8,200 (or $10,000) is subject to the 5% surrender charge: about $410–$500, plus any market value adjustment if the contract has one.
• Remaining contract stays on its original schedule and keeps its remaining free-withdrawal windows.

Option B - full surrender.

• Surrender charge ≈ 5% of the $250,000 purchase payment = $12,500.
• Cash out ≈ $255,500, with $18,000 of gain realized and taxable as ordinary income now.

Full surrender and 1035 exchange.

• A 1035 exchange defers the $18,000 of gain, but it does not produce the $35,000. She would still have to withdraw from the new contract, which sits in surrender-charge year 1 of a 10-year schedule - the most expensive year to take money out.
• The 10% bonus is typically funded through lower caps or participation rates and is often recaptured on early withdrawal or surrender, so it may be illusory for a client who needs cash soon.

On the numbers, the free withdrawal (or splitting it across two contract years) is far cheaper than a full surrender.

The exchange fails a best-interest review on these facts.

• Liquidity mismatch. A 10-year surrender schedule starting at age 76 locks the money until age 86 for a client whose only liquid reserves are $15,000 and who already has an identified $35,000 need.
• Sunk cost. She is three years into a seven-year schedule. Surrendering now forfeits that progress and restarts the clock with nothing gained except a bonus that carries its own recapture terms.
• Reasonably foreseeable changes. Age, health, and the absence of an emergency fund all point toward needing access, not toward a decade-long commitment.
• Cost comparison. The producer must compare the existing contract's surrender charge, death benefit, living benefits, and crediting features with the proposed contract's - including caps, participation rates, and bonus vesting - not just the headline bonus.

What to do instead: recommend keeping the existing contract and using the free-withdrawal provision, possibly over two contract years, or bridging with savings. If a replacement is still being considered, deliver the required replacement notice and disclosure of surrender charges, obtain the client's written acknowledgment, and be prepared to justify why the exchange is not just suitable but better.

Documentation: client goals and time horizon, liquidity needs, the specific cost comparison of both contracts, the alternatives considered and rejected, and the effect of surrender charges and bonus recapture.

Nonqualified annuity withdrawals are taxed on a last-in, first-out basis.

• With a $250,000 basis and a $268,000 value, $18,000 is untaxed gain sitting on top of the contract.
• The first $18,000 of the $35,000 withdrawal is taxable as ordinary income; the remaining $17,000 is a return of basis and is not taxed.
• Because the withdrawal is less than the accumulated gain, none of her $250,000 basis is recovered beyond that $17,000; her remaining basis becomes $233,000.
• The 10% additional tax on early distributions from annuities does not apply - it stops applying at age 59½, and she is 76.

Contrast with annuitization: if she annuitized instead, each payment would be split by an exclusion ratio, with the portion representing her investment in the contract excluded from income until basis is recovered. That produces a smoother tax profile but is irrevocable, which is the wrong fit for a one-time $35,000 need.

The producer should also confirm the withdrawal mechanics (charge-free amount, timing of the free window) before she takes anything, since a taxable event plus a surrender charge is the worst combination.