A Nursing-Home Cash Need and a Producer's 1035 Recommendation
Eleanor, 74, owns a nonqualified fixed deferred annuity with a $180,000 account value and $150,000 of basis. The contract is in year 3 of a 7% surrender charge that drops one point each year, permits a 10% free withdrawal annually, and waives surrender charges if the owner is confined to a nursing facility for 30 days. Eleanor entered a nursing home in January and needs $40,000 this year for care that Medicare and Medicaid will not cover. Her producer suggests a 1035 exchange into a new annuity paying a 5% premium bonus with a fresh nine-year surrender schedule. Social Security and her pension cover her other expenses, and her marginal tax rate is 22%.
1. Ignoring the exchange, how much would Eleanor actually net from a $40,000 withdrawal from her current contract, and how much of it is taxable?
Read the worked answer
Net cash and taxation:
- Free withdrawal: 10% of $180,000 = $18,000 with no surrender charge.
- Remaining $22,000 at the year-3 surrender charge of 7% = $1,540 charge, so $20,460 net.
- Total net if the charge applies: $38,460 - she would be short of the $40,000 care bill.
- But the nursing-home waiver likely applies. She has been confined since January, well past the 30-day trigger, so the $1,540 charge should be waived: net $40,000.
Tax: nonqualified annuity withdrawals are taxed gain-first. Gain = $180,000 − $150,000 = $30,000, or 16.7% of the contract value. Taxable amount = $40,000 × 16.7% ≈ $6,667 of ordinary income; the other $33,333 is return of basis and tax-free. The 10% early-withdrawal penalty does not apply because she is over 59½.
Judgment point: the first move is not a withdrawal calculation - it is reading the waiver provision and the free-withdrawal clause. The waiver turns a $1,540 haircut into zero.
2. Evaluate the proposed 1035 exchange. Would you sign the suitability paperwork?
Read the worked answer
No - I would not recommend or document this exchange as suitable.
- A 1035 exchange preserves basis and tax deferral. It does not preserve the old contract's surrender schedule, free-withdrawal percentage, or nursing-home waiver. Those are exactly the features she is using right now.
- A fresh nine-year schedule runs to age 83 - precisely the years when long-term care and liquidity needs rise. Her stated need is current cash, not decades of accumulation.
- The 5% bonus ($9,000) is typically recovered through lower crediting rates, an MVA, or a longer schedule; against her immediate need it is illusory. She would also be surrendering a contract already past the steepest charge years.
- Best-interest/suitability standards require a documented reasonable basis, consideration of surrender charges, liquidity needs, age, health, and reasonably available alternatives, and disclosure of the costs of the exchange.
Alternatives to present: exercise the nursing-home waiver and take $40,000; take the 10% free amount plus a smaller charged withdrawal; or annuitize a portion of the contract if she wants guaranteed monthly income to supplement the care bill.
Judgment point: a bonus is a sales feature, not a suitability finding. The correct comparison is surrender-cost-now versus liquidity-cost-later, and at 74 with an active care need the later cost dominates.
3. What changes if the $40,000 need will repeat every year for three years, and she may eventually apply for Medicaid?
Read the worked answer
Multi-year analysis:
- Three years of $40,000 is $120,000 - two-thirds of the contract. A single large withdrawal each year exhausts the free amount and, absent the waiver, produces repeated surrender charges. If the waiver is one-time or conditioned on continuous confinement, model each year separately.
- Annuitization of a portion may be the better fit: it converts a lump-sum drain into monthly income that can be matched to the facility's monthly charge, and it removes the temptation of ad hoc withdrawals. Note that annuitization is irrevocable and should be sized to leave an emergency reserve.
- Medicaid interaction: the annuity is a countable resource for long-term-care Medicaid. Withdrawals spent on care reduce the countable estate, but transfers for less than fair value within the look-back period create a penalty period. A 1035 exchange is not a transfer for less than fair value, but the bonus, the new surrender schedule, and any change of ownership or annuitant must be reviewed with elder-law counsel before signing.
Judgment point: once public benefits enter the picture, the producer's job is to slow down, document the client's stated objective, and coordinate with a qualified adviser - not to move assets into a longer surrender schedule.