The 1035 Exchange at 68
Rita, 68, owns a nonqualified fixed deferred annuity worth $300,000 with a $180,000 cost basis. She has held it nine years, and its surrender charges have fully expired. Her agent proposes a 1035 exchange into a fixed indexed annuity with a new 10-year surrender schedule starting at 9% and dropping one point per year, a 10% annual free withdrawal, and a market value adjustment. Rita expects to need $40,000 in 18 months to replace a roof, and she wants to begin lifetime income around age 75. She is in the 24% federal bracket, has $60,000 in other savings, and her income is Social Security plus a small pension.
1. If Rita completes the exchange, how should she time the $40,000 withdrawal, and what will it cost?
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The free withdrawal amount is 10% of the contract value per contract year - roughly $30,000 in year one.
Best sequencing:
- Contract year 1: withdraw $30,000 - entirely within the free amount, so no surrender charge and no MVA.
- Contract year 2: withdraw the remaining $10,000 - still inside that year's 10% free allowance (now based on the higher anniversary value), so again no charge.
If she instead took $40,000 in a single year-one withdrawal: $10,000 exceeds the free allowance, and year-one surrender charge is 9%, i.e. $900, plus a possible market value adjustment, which could add more depending on rate movement.
Tax note: withdrawals from a nonqualified annuity are taxed gains-first (LIFO). Her gain is $300,000 − $180,000 = $120,000, so the entire $30,000 in year one and $10,000 in year two are ordinary income - roughly $40,000 × 24% ≈ $9,600 of tax - until the $120,000 gain is exhausted. She should not assume the withdrawal is partly a tax-free return of basis.
2. Evaluate the suitability of the 1035 exchange and identify a less aggressive alternative.
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A 1035 exchange is tax-free, so the $120,000 gain stays sheltered - that is the real attraction. But weigh it against what she gives up:
Against the exchange
- She is 68 and would take on a surrender period running to roughly age 78.
- She has a known $40,000 liquidity need in 18 months; a new contract adds penalties and an MVA exactly when she needs money.
- Her current contract has already burned off nine years of charges; she would be restarting the clock.
- She needs income at 75 - inside the new surrender period.
For the exchange
- Continued tax deferral on $120,000 of gain.
- Possibly richer income or living-benefit features, if she actually needs them.
Suitability conclusion: on these facts the exchange is hard to justify. The liquidity need, her age relative to a 10-year schedule, and the availability of $60,000 in other savings all point the other way.
Better alternative: keep the existing contract and withdraw the $40,000 over two tax years from an annuity with no surrender charge. She pays ordinary income tax on the gain but no penalty, no MVA, and no locked-in schedule - and she stays liquid at 75.
3. Instead of withdrawing, Rita annuitizes the existing contract. With a monthly payment of $2,000 and an expected return of $360,000, what is the exclusion ratio and how is each payment taxed?
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The exclusion ratio allocates each payment between return of her basis and taxable gain:
- Investment in the contract: $180,000
- Expected return: $360,000
- Exclusion ratio: 180,000 ÷ 360,000 = 0.50, or 50%
So of each $2,000 monthly payment:
- $1,000 excluded from income (return of basis)
- $1,000 taxable as ordinary income
How long it lasts: the exclusion applies until her full $180,000 basis has been recovered - about 180 payments, or 15 years, taking her to roughly age 83. After that, the entire $2,000 is taxable.
If she dies before recovering basis: the unrecovered amount is generally deductible on her final return, which is why the basis figure must be documented.
Key distinction: once she annuitizes, the contract is irrevocable. The exclusion ratio is fixed at the annuity starting date, so it does not adjust for later changes in payout.