A 1035 Exchange at 71: Weighing Guaranteed Income Against a New Surrender Period
Eleanor, 71, owns a nonqualified fixed deferred annuity with a $420,000 contract value and a $250,000 investment in the contract. It is in year 3 of a 7-year surrender charge schedule; the current charge is 5%. Her life expectancy is roughly 15 years. She has $600,000 in other liquid assets and a $3,400 monthly Social Security benefit, and she does not expect to need the annuity's principal. She wants guaranteed lifetime income of about $2,500 a month. Her agent recommends a 1035 exchange into a new indexed annuity with a fresh 10-year surrender charge schedule and a guaranteed lifetime withdrawal benefit rider costing 1.25% annually; the new contract, with the rider, would produce roughly $2,600 a month beginning now.
1. If Eleanor surrendered the existing contract today instead of exchanging it, what would she owe in tax? Show the computation and the rules you applied.
Read the worked answer
She would receive about $399,000 and report $149,000 of ordinary income.
- Surrender charge: 5% × $420,000 = $21,000, so net cash is $399,000.
- Gain = amount received − investment in the contract = $399,000 − $250,000 = $149,000.
- LIFO / gain-first rule: in a nonqualified annuity, withdrawals and surrenders come out of gain first, so the entire $149,000 is taxable - no proration, no capital-gain treatment. It is ordinary income.
- No 10% premature distribution penalty, because she is past 59½.
- The surrender charge is not separately deductible. It simply reduces the amount she receives and therefore her taxable gain (compare: gain before the charge would have been $170,000).
- Maryland income tax applies to the $149,000 as well; the federal figure is not the whole bill.
2. Evaluate the agent's recommendation. Is the exchange suitable, and what alternatives or conditions belong in the file?
Read the worked answer
Defensible, but not obviously the best choice - and the file needs a real comparison before it is sold.
Points in favor
- A 1035 exchange preserves tax deferral on $170,000 of embedded gain; surrendering would trigger $149,000 of ordinary income.
- Her stated objective is guaranteed lifetime income, and the GLWB addresses it. She has $600,000 of other liquid assets, so locking up this contract is less harmful than it would be for a client with no other reserves.
Points against
- A new 10-year surrender charge schedule runs to age 81 - precisely when the odds of needing a lump sum for home care or nursing-home costs spike.
- Rider cost is 1.25% × $420,000 ≈ $5,250 a year, drawn from the contract value and compounding against her.
- Annuitizing the existing contract avoids a new surrender period and the rider fee entirely and still delivers a guaranteed lifetime payment; she should be shown that guaranteed number side by side with $2,600.
- She may also quality for a partial annuitization or systematic withdrawals at lower cost.
Conditions to satisfy before submitting
- Document the comparison of guaranteed income under: existing contract annuitized vs. exchanged contract with rider vs. exchanged contract without rider, net of fees and charges.
- Confirm the replacement is disclosed on the state replacement/suitability forms and that the agent's compensation is disclosed.
- Shop contracts with shorter surrender periods - a 1015 or 7-year schedule may deliver similar income with less lock-up.
- Verify the existing contract's own guaranteed income features; many older fixed contracts have valuable annuitization rates that are forfeited on exchange.
3. After a 1035 exchange, what is Eleanor's basis in the new contract, and how is the contract taxed if she dies without annuitizing?
Read the worked answer
Basis carries over, and the gain never gets a step-up.
- Basis: under §1035, the $250,000 investment in the old contract becomes the investment in the new contract. The exchange is not a taxable event, so no gain is recognized and no basis is created.
- Death before annuitization: the beneficiary receives the contract value or the contractual minimum death benefit, and the excess over $250,000 is ordinary income to the beneficiary - there is no basis step-up for annuities, unlike life insurance. That is the planning point clients routinely miss.
- Death during annuitization: if she had annuitized and died inside a guaranteed period, remaining payments continue to the beneficiary and retain the same exclusion-ratio character - the tax-free portion stays tax-free until her basis is fully recovered, then payments become fully taxable.
- Practical consequence: if the goal is a legacy for heirs, an annuity is a poor vehicle compared with life insurance, and the exchange should be evaluated with that in mind rather than on income alone.