Gloria's $60,000: Withdrawal, Annuitization, or 1035?
Gloria S., 63, of Grand Island, owns a nonqualified fixed deferred annuity bought six years ago for $120,000. It is now worth $180,000. Her seven-year surrender schedule charges 3% in year six, falling to 1% in year seven, and she may withdraw 10% of contract value each year without a surrender charge. The contract has never been annuitized and she has never taken a distribution. She needs $60,000 for a new roof, and she is also considering converting the entire contract to lifetime income. The carrier quotes $1,500 a month for life with payments guaranteed for 10 years, on an expected return of $300,000.
1. Calculate the tax and the surrender charge on a $60,000 withdrawal.
Read the worked answer
Tax - gain first (LIFO)
- Gain in the contract: $180,000 − $120,000 = $60,000.
- Pre-annuitization withdrawals come out gain-first. A $60,000 withdrawal is therefore 100% taxable as ordinary income.
- Basis stays at $120,000; contract value falls to $120,000, so the remaining gain is now zero.
- No 10% penalty: she is 63, past 59½. (Had she done this at 58, $6,000 of penalty would have been added to the tax.)
Surrender charge
- Free withdrawal: 10% × $180,000 = $18,000, no charge.
- Chargeable amount: $60,000 − $18,000 = $42,000.
- Charge: $42,000 × 3% = $1,260.
Total cost of the roof: $60,000 of ordinary income (roughly $13,200–$22,200 of federal tax at 22–37%, plus Nebraska tax) plus a $1,260 charge. Note that waiting one year drops the charge to 1% ($420) - the timing question is worth $840 and should be put to her explicitly.
2. If she instead annuitizes the entire contract, what part of each $1,500 payment is taxable, for how long, and what happens if she dies early?
Read the worked answer
Exclusion ratio
- Investment in the contract ÷ expected return = $120,000 ÷ $300,000 = 40%.
- Each $1,500 payment: $600 excluded (return of her own basis), $900 taxable as ordinary income.
- The exclusion applies until her entire $120,000 basis is recovered - $120,000 ÷ $600 = 200 payments, about 16 years and 8 months. After that, 100% of each payment is taxable.
If she dies before recovering basis
- Her beneficiary receives the guaranteed payments; the unrecovered investment in the contract ($120,000 less the exclusions already taken) is deductible on her final income tax return under the annuity rules. Families routinely miss this deduction - flag it in the file.
- The 10-year period certain does not change the exclusion ratio (that is computed from expected return, not the guarantee), but it does guarantee the beneficiary roughly the remaining certain payments.
The trade-off to make explicit: annuitization is irrevocable. She converts a $180,000 asset she controls into a payment stream, at a moment when interest rates - not her needs - set the payout. Annuitizing the whole contract to fund a $60,000 roof is using a lifetime-income tool as an ATM.
3. She is also offered a 1035 exchange into a new annuity with an income rider. Compare the three paths and recommend one.
Read the worked answer
Path 1 - Partial withdrawal ($60,000)
- Keeps control and liquidity; pays $1,260 in charges.
- Taxes the whole $60,000 at ordinary rates now, and wipes out her remaining gain, so the residual $120,000 grows from a zero-gain position.
Path 2 - Annuitize the whole contract
- Locks a lifetime income with a 40% exclusion ratio and an irrevocable decision at age 63; no liquidity, no inflation protection unless bought.
- Best only if she has no other assets and genuinely needs a pension she cannot outlive.
Path 3 - 1035 exchange into a new annuity with an income rider
- No tax now; the $120,000 basis carries over and deferral continues.
- But she starts a new surrender period and possibly a new market value adjustment, adds rider fees, and the income rider's "benefit base" is not a cash value - beneficiaries often receive far less than the rider illustration implies.
Recommendation: she needs $60,000 once, not lifetime income. If she has the cash elsewhere, use it and leave the annuity alone. If not, take the partial withdrawal, accept the $1,260 charge, and schedule it after the surrender charge drops to 1% if the roof can wait. An exchange to a new contract to solve a one-time cash need adds cost without solving anything.