A Deferred Annuity Withdrawal, a 1035 Exchange, and a Stray MEC
Sal, 67, bought a nonqualified fixed deferred annuity 12 years ago with a single $120,000 premium. It is now worth $180,000, but the surrender value is $172,000 because of a declining surrender charge. Sal wants $30,000 for a home renovation. His advisor instead proposes a 1035 exchange into a lower-cost annuity. Sal also mentions an old variable annuity he bought in 2009 that his accountant has labeled an 'MEC,' and asks whether that changes anything. Sal is in good health, does not need retirement income, and his marginal ordinary income rate is 24%. He has no capital losses to offset anything.
1. If Sal takes the $30,000 withdrawal, how much is taxable and what is his remaining basis and gain?
Read the worked answer
All $30,000 is ordinary income; federal tax ≈ $7,200; basis stays $120,000.
- Nonqualified annuity withdrawals follow LIFO (gain first): of the $60,000 of gain ($180,000 value − $120,000 basis), the first dollars out are earnings. Sal has plenty of gain, so the entire $30,000 is includible.
- No 10% premature-distribution penalty - Sal is over 59½. (Had he been 55 and separated from service, that exception applies only to qualified plans, not annuities.)
- Tax: $30,000 × 24% = $7,200. No capital-gains treatment; annuity gain is never capital gain.
- After the withdrawal: contract value $150,000 (less any surrender charge actually deducted), basis unchanged at $120,000, remaining unrealized gain $30,000.
Note the surrender charge: the taxable amount is the gross distribution, so a $30,000 request that nets $24,000 after charges still produces $30,000 of income.
2. How does the proposed 1035 exchange change the tax result, and what should Sal watch for?
Read the worked answer
The exchange defers the tax entirely - but only if it is done correctly.
- IRC §1035 permits an annuity-to-annuity exchange with no recognition of gain. Sal would pay $0 now instead of $7,200.
- Basis carries over: the new contract inherits the $120,000 basis, so the $60,000 of built-in gain remains and will be taxed as ordinary income later.
- Constructive receipt kills the deal: a check made payable to Sal, or a surrender followed by a new application, is a taxable distribution. Use a direct trustee-to-trustee transfer.
- New surrender charge schedule: exchanging into another contract restarts the surrender period; if Sal might need liquidity, he may be trading a small current tax for a new liquidity lock-up - which is why a partial exchange or a smaller withdrawal may be the better fit.
- Compare like with like: a lower expense charge on a 12-year-old contract must beat whatever he is leaving, and the exchange resets any living-benefit rider terms.
Recommendation framework: if the $30,000 is genuinely needed, take the withdrawal and pay the $7,200; if it is not needed, exchange the whole contract directly and preserve the deferral.
3. Sal's 2009 contract is a modified endowment contract. What does that mean for withdrawals from it and for any exchange of that contract?
Read the worked answer
MEC status follows the money.
- A MEC is a life-insurance contract that failed the 7-pay test. It is still life insurance, but distributions are taxed less favorably.
- Withdrawals, loans, and assignments are taxed gain-first with no cost-recovery treatment, and pre-59½ distributions carry a 10% penalty. Sal is 67, so no penalty applies, but the income is still ordinary income.
- MEC status transfers on exchange. A §1035 exchange of a MEC into another annuity or life policy generally produces another MEC, so exchanging cannot 'cleanse' the contract.
- Practical warning: do not merge the MEC into the fixed annuity Sal is keeping. Because basis and gain are aggregated on a contract-by-contract basis, commingling can taint the good contract and destroy its more favorable cost-recovery treatment. Keep the MEC separate or exchange it only into its own new contract with eyes open.
- Also confirm whether the older contract has a living benefit or guaranteed minimum that would be forfeited - the tax tail should not wag the contract dog.