Partial 1035 Exchange When the Bonus Comes With a Ten-Year Lock
Dana, 68, bought a nonqualified deferred annuity three years ago with a $200,000 deposit. The surrender charge schedule is 9% in year one, declining by one point each year, and the contract permits a 10% free withdrawal each year. The account value today is $212,000, of which $180,000 is basis. Dana's advisor wants her to move $120,000 into a new annuity that pays a 7% premium bonus and carries a fresh 10-year surrender schedule plus a market value adjustment. Dana has no immediate income need, takes Social Security, and has a $30,000 emergency fund.
1. If Dana withdraws $120,000, what surrender charge applies and how much cash does she actually receive? Show the math, including the tax treatment.
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Two calculations run at once. First, the free-withdrawal band: 10% of the $212,000 account value is $21,200, which comes out with no surrender charge. The remaining $98,800 sits inside the surrender schedule. Year three of a 9%-declining-by-one schedule is 7%, so the charge is $98,800 × 0.07 = $6,916. Net check in hand: $120,000 − $6,916 = $113,084.
Confirm the contract's measurement base, because it changes the answer: if the free amount is measured against the $200,000 premium rather than account value, only $20,000 is free and the charge rises to $7,000. On the tax side, withdrawals from a nonqualified annuity are taxed LIFO, so the $32,000 of gain ($212,000 − $180,000 basis) is deemed distributed first and is ordinary income; the balance is basis and tax-free. Dana is past 59½, so the 10% penalty under IRC §72(q) does not apply.
2. Is the partial 1035 exchange mechanically available, and what suitability issues should be documented?
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Mechanically, yes. A partial exchange between annuity contracts is generally permitted, so the $120,000 can move without recognizing the built-in gain; basis carries over pro rata and tax deferral continues. The real question is suitability, and there are three red flags.
First, the 7% bonus is typically recovered by the insurer through lower caps or participation rates, or through a bonus recapture period if she withdraws early. Second, a fresh 10-year schedule runs to age 78, trading three years of remaining surrender exposure for ten. Third, the market value adjustment is an additional exit cost stacked on the surrender charge. Before signing, compare the guaranteed minimum values and current renewal rates on the existing contract, and document in the file why the exchange benefits her rather than the advisor. Replacement regulations require that comparison, and a pattern of exchanges into bonus products is a classic market-conduct finding.
3. Dana dies in year four, before annuitization. What happens to the money?
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Death benefits are typically exempt from surrender charges and market value adjustments, so the beneficiary receives at least the contract's death benefit, often the greater of account value or a guaranteed minimum. Income tax falls only on the gain over basis; the basis portion is not income.
Assuming a non-spouse beneficiary, the SECURE Act generally requires the inherited annuity to be fully distributed within 10 years, with annual required distributions in some configurations under the final regulations. So the realistic choices are a lump sum or a payout over up to 10 years, not a lifetime stretch. Spousal continuation, where the surviving spouse steps into the contract as owner and keeps deferral intact, is available only if the beneficiary is a spouse. Nothing here changes if she had annuitized, except that the remaining payments would pass to the beneficiary under the settlement option's terms.