The 1035 Exchange Rhonda Was Talked Into
Rhonda, 68, retired last year from teaching. She has $180,000 in a 403(b) fixed annuity she has held for 14 years, $40,000 in a savings account, and $2,100 a month in Social Security. An agent recommends a 1035 exchange into a new indexed annuity with a 10-year surrender schedule (9% in year one, declining one point a year), a 1.25% annual income rider fee, a 6.5% cap, and a 0% floor. She would need income of about $12,000 a year beginning at age 72. The existing 403(b) contract carries a $6,000 surrender charge and a 3% guaranteed minimum interest rate. Rhonda says she wants "the highest number on the page" and does not want to lose money.
1. Is this replacement suitable? Identify the specific facts that cut for and against it.
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Against suitability:
- The 10-year surrender schedule runs to age 78, well past the point at which she expects to draw income and uncomfortably close to the horizon for a retiree with only $40,000 of liquid assets.
- She needs income in four years. Paying a 9% charge in year one, or being locked in at all, directly conflicts with a four-year liquidity need.
- She is surrendering a 3% guaranteed minimum interest rate - an actual guarantee - for a 6.5% cap that is a ceiling, not a promise, plus a 1.25% fee drag every year.
- "The highest number on the page" signals she is relying on a non-guaranteed illustration; the agent has an obligation to distinguish illustrated from guaranteed values.
For suitability: the 0% floor does protect principal from market loss, the $40,000 cushion plus Social Security covers near-term cash needs, and an income rider can guarantee a withdrawal base for life.
Conclusion: the replacement is hard to justify. Retaining the 3% contract and drawing income from it, or purchasing a shorter-surrender or immediate annuity, better fits her facts. Annuity suitability standards require reasonable grounds based on age, liquidity, income, and financial objectives, documented and supervised - and "I wanted a bigger illustration" is not a reasonable ground.
2. Assume Rhonda signs and the transfer is processed as a 1035 exchange from the 403(b) into a nonqualified annuity. What are the tax consequences, and how is the $6,000 surrender charge treated?
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This is not a 1035 exchange. Section 1035 defers gain only between contracts of the same tax character. Moving 403(b) money into a nonqualified annuity is a distribution of the full $180,000, ordinary income in the year received (she appears to have no after-tax basis, since 403(b) contributions were pre-tax). The 10% early-distribution penalty does not apply because she is past 59½, but the income tax hit could still be substantial.
To stay tax-free the money must move trustee-to-trustee into another 403(b) or into an IRA.
The surrender charge is not deductible. It reduces what she nets, but the taxable amount is measured on the gross amount distributed. It also does not recreate basis in the new contract beyond the amount actually reinvested.
This is the kind of error that gets an agent disciplined: the suitability problem is arguable, but mislabeling a taxable distribution as a tax-free exchange is a clear failure, and the client bears the tax cost.
3. Rhonda signs the application at the meeting. The contract is delivered 11 days later, and she calls the next morning to cancel. What are her options?
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She is almost certainly inside the free-look period, which runs from delivery of the contract, not from the date she signed the application - a distinction clients frequently get wrong and agents sometimes exploit. The typical period is 10 days; many states extend it to 20 or 30 days when the sale involves a replacement.
Within that window she can return the contract for a full refund of the premium or account value, and the transaction is treated as though the contract had never been issued, so the exchange back out should not create a taxable event. She should put the cancellation in writing and keep proof of delivery.
What the agent should do: process the cancellation without friction and confirm in writing that the original contract will be restored. If the original 403(b) has already been liquidated and cannot be reinstated, that is itself evidence that the replacement was mishandled. She should also be told she can raise the suitability question with the insurer's compliance area or the state insurance division. Confirm the exact free-look length under current state law and the contract's own provision before advising on deadlines.