The $45,000 Renovation and the 10-Year Surrender Schedule
Ruth, 74, is a widow with $250,000 in a fixed deferred annuity that is 11 years old and past its surrender-charge period. She receives $1,400 a month in Social Security, has $60,000 in a savings account, and expects to spend about $45,000 within roughly 18 months to widen doorways and add a ramp so she can stay in her home. An agent proposes a 1035 exchange into an indexed annuity with a 10-year surrender schedule (10% in year one), an 8% cap, a 0% floor, a 1.30% annual income rider fee, and a 6% premium bonus that vests over ten years. He tells her the bonus is "free money" and she "cannot lose a dime."
1. Walk through the suitability analysis. Which features of the proposal conflict with Ruth's facts?
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The liquidity mismatch is dispositive. She needs $45,000 in about 18 months. A 10% first-year surrender charge on a $250,000 contract means withdrawing $45,000 in year one could cost roughly $25,000 in charges alone. The product's structure is incompatible with a known, dated cash need.
The bonus is not free. Premium bonuses are typically recovered through a lower cap or participation rate, a longer surrender schedule, or direct recapture on early withdrawal. A 6% bonus vesting over ten years offered to a 74-year-old is a commission-and-persistence design, not a client benefit.
The 0% floor is not a guarantee against loss. The floor protects the index credit, but the 1.30% rider fee and contract expenses can still erode contract value, and the rider only pays off if she actually annuitizes or takes lifetime income - which conflicts with needing a lump sum.
The cap limits the upside she is being sold. At an 8% cap with a 0% floor, she gives up index gains above 8% in exchange for downside protection she does not need on money earmarked for a ramp.
Best-interest standard: the recommendation must reflect her needs, not the compensation differential.
2. How should the agent actually handle the 1035 exchange and the $45,000 need? Be specific about mechanics and taxes.
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Split the money by time horizon. Money needed within 18 months does not belong inside a new surrender schedule. The existing contract is already out of its surrender period, so the cleanest route is a partial withdrawal from the current annuity, keeping the rest in place.
Tax mechanics of a partial withdrawal: annuity withdrawals are taxed income-first (LIFO) to the extent of gain, so she will owe ordinary income tax on the gain portion. The 10% early-withdrawal penalty does not apply - she is over 59½. She should also confirm the contract's own partial-withdrawal rules.
If a 1035 exchange is still appropriate for a portion: it must be annuity-to-annuity, executed as a direct trustee-to-trustee transfer so she never takes constructive receipt. A check made payable to her personally destroys the tax-free treatment and could make the entire gain taxable.
Document the alternatives: explain staying put, a partial withdrawal, a shorter-surrender product, and a CD or money market for the renovation funds. Then let her choose with the tradeoffs in writing.
3. Ruth signed the application yesterday and now has second thoughts. What are her options, and what happens to the exchanged money?
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Free look. Annuity contracts carry a state-mandated free-look period (commonly 10 days from delivery; confirm the exact number in the contract and current statute). If she exercises it, the contract is rescinded and premium is returned - and because the money came in by 1035 exchange, the funds must be transferred back to the original contract or a successor vehicle to preserve tax deferral. She should not take a personal check.
If the free look has run: surrender charges apply, plus possible recapture of any bonus credited. That is the moment the suitability file matters - the agent's documented rationale, the disclosed fees, and the comparison of alternatives will determine whether the sale survives review.
Remedies: she can file a suitability complaint with the state insurance regulator, and the insurer has its own suitability review obligations. The agent who told a 74-year-old that a bonus is "free money" and that she "cannot lose a dime" has created a misrepresentation problem independent of suitability.