A 1035 Exchange Into a Bonus Fixed Indexed Annuity With an 18-Month Cash Need
Walter, 68, holds $300,000 in a nonqualified variable deferred annuity with a $180,000 cost basis. The surrender charge is 2% if he moves the money now, and it disappears in eight months. An agent proposes a 1035 exchange into a fixed indexed annuity with an 8% premium bonus, a 10-year surrender schedule with a market value adjustment, and a 1.25% annual income-rider fee; the bonus vests over ten years and is recaptured on early surrender. Walter wants the largest guaranteed lifetime income he can start at age 70, and he expects to need about $60,000 for a roof and structural repair in roughly 18 months. He is in good health, has other retirement income, and needs no liquidity for ordinary expenses. The FIA permits one 10% free withdrawal each year.
1. Is the proposed exchange suitable as structured? Quantify the costs and describe the better sequencing.
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Costs of moving now:
- Surrender charge on the old contract: 2% x $300,000 = $6,000, which evaporates in eight months - he is being asked to pay for pure timing.
- The 8% bonus looks like $24,000, but it typically credits the income benefit base or a vesting value that is clawed back on early surrender; it is not free money sitting in the account.
- A fresh 10-year surrender schedule with MVA at age 68 locks the money until roughly age 78. The 1.25% rider fee is an annual drag on account value.
The liquidity mismatch is decisive: he needs $60,000 in 18 months, but the free withdrawal is only 10% of value (about $32,000 with the bonus). The remaining ~$28,000 would trigger a surrender charge, an MVA, and bonus recapture. Placing money he knows he needs in 18 months into a 10-year contract is the classic unsuitable exchange.
Better sequence: wait eight months so the $6,000 charge disappears; take the $60,000 from the existing contract at that point (taxable, but no surrender charge); then decide whether to exchange the remainder. The analysis should compare the existing contract's guaranteed income against the FIA's guaranteed income net of the 1.25% fee, and record the comparison in the suitability file with the replacement disclosure.
2. Walter takes $60,000 from the existing contract instead. How is it taxed, and how would taxation differ if he annuitized the whole $300,000 with an expected return of $450,000?
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Withdrawal - LIFO. Nonqualified annuity distributions come out gain first. Gain = $300,000 - $180,000 = $120,000, so the entire $60,000 is ordinary income; no part of the basis is recovered. No 10% penalty applies because he is past 59½. Afterward the contract is worth about $240,000, basis remains $180,000, and only $60,000 of gain remains to be taxed on future distributions.
Annuitization - exclusion ratio. Investment in the contract divided by expected return: $180,000 / $450,000 = 40%. Each payment is 40% tax-free and 60% taxable, and the exclusion continues only until the full $180,000 of basis has been returned; after that, every dollar is taxable. If he dies before recovering the basis, the unrecovered amount is deductible on his final return.
Why it matters: the withdrawal he needs is 100% taxable, while annuitizing spreads basis recovery across payments. But annuitizing is irrevocable and gives up control of the principal, so it should not be done just for tax optics.
3. Suppose he ignores the advice, completes the exchange, and withdraws $60,000 in month 18. What happens to the contract and to his taxes?
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Taxes: LIFO still governs. Roughly $294,000 transfers after the $6,000 surrender charge, the 8% bonus adds about $23,500, so contract value is around $317,500 against $180,000 of carried-over basis - about $137,500 of gain. The $60,000 withdrawal is therefore fully taxable ordinary income, even though he is partly taking back his own basis.
Contract charges: the 10% free withdrawal is only about $31,750. The remaining ~$28,250 hits the surrender schedule (year-two charges are still steep), an MVA if rates have moved against him, and recapture of the bonus allocated to that amount. So he pays tax on the full $60,000 and a penalty stack on roughly half of it.
Lesson to articulate in the file: any money with a known use inside the surrender period should never be placed in the contract, and the free-withdrawal percentage - not the account value - is the real liquidity limit.