Series 6: Variable Products (Variable Annuity Taxation)

An owner of a variable annuity contract has paid in $20,000 in premiums. Due to an emergency cash need, she surrenders the contract prior to annuitization. At that time, the NAV is $16,000. There is a surrender charge of 4%. The tax consequence of this event is:

$4,640 ordinary loss If $20,000 is contributed and the contract is surrendered when it has a NAV of $16,000, then there is a loss on the contract. Because of the 4% surrender fee, the net amount received upon surrender is $15,360. Because the contract was purchased for $20,000, the loss amount is $4,640. Annuity taxation rules treat this as an ordinary loss, meaning that it can be deducted in full against ordinary income. This is only fair because any gain in the separate account is taxed as ordinary income, not as capital gains.

A 10% penalty tax is imposed on distributions from non-qualified variable annuities taken prior to age:

59 1/2 The "magic" age for any retirement plan, whether it is qualified or non-qualified, is 59 1/2. Distributions taken at age 59 1/2 or later are only subject to ordinary income tax rates. Distributions taken prior to age 59 1/2 are subject to ordinary income tax rates plus a 10% penalty tax. Also, remember that 100% of the distribution from a qualified plan is subject to these tax rules; while a distribution from a non-qualified plan is only subject to taxation on the "build-up" portion (pre-tax dollars) and not on the portion of the distribution attributable to original investment (post-tax dollars).

Tony, a new client, brings in a check issued by the insurer with proceeds from a partial surrender of a variable annuity. He asks the registered representative to initiate a tax-free exchange into a new annuity funded by the check proceeds. What action should the registered representative take?

Decline the transaction because a Section 1035 exchange may not be funded with a check from the previous annuity The tax code requires that the owner must exchange the old contract for a new contract in order to have a "tax-free" exchange. This can either be done as an exchange for either a partial or full surrender. If a check is taken for the proceeds of liquidating the old contract, this is a "tax event" and any gain on the liquidation now becomes taxable.

IRS regulations require lump sum distributions from non-qualified variable annuities to be taxed on a:

LIFO basis The IRS requires that LIFO (Last In: First Out) accounting be used when lump sum distributions are taken from a non-qualified plan. Because the separate account "build-up" (pre-tax dollars) were the "Last-In," the first dollars coming out are considered to be attributable to the "build-up." These are 100% taxable dollars. Once the "build-up" portion has been depleted, the remaining dollars taken out represent the original post-tax investment dollars (the cost basis). These are returned without tax due. Also note that the LIFO accounting rule only applies to withdrawals prior to annuitization. It does not apply once the account is annuitized. Instead, upon annuitization, a fixed percentage of each payment representing the cost basis is excluded from taxation based upon that individual's life expectancy.

Which statements are true about retirement plans? I Contributions to a qualified plan are made with pre-tax dollars II Contributions to a qualified plan are made with post-tax dollars III Distributions from a qualified plan are taxable IV Distributions from a qualified plan are not taxable

I and III A qualified retirement plan is one that "qualifies" for favorable tax treatment under the tax code. Annual contributions to qualified plans are limited in amount and are tax-deductible. Thus, these contributions are made with "pre-tax" dollars. Earnings in the account build tax-deferred. When distributions are taken at retirement age (59 1/2 or later), the entire distribution is taxable, because none of the dollars in the account were ever taxed. A non-qualified retirement plan is one that does not qualify for favorable tax treatment under the tax code. Annual contributions to non-qualified plans are not subject to limitations and are not deductible. Thus, these contributions are made with "post-tax" dollars. Earnings in the account build tax-deferred. When distributions are taken at retirement age (59 1/2 or later), only the portion of the distribution attributable to the "build-up" is taxable (these dollars were never taxed and are "pre-tax" dollars). The portion of the distribution that is attributable to the original investment dollars is a return of capital that is not taxable (since there was no deduction for the investment, these are "post- tax" dollars).

James elected the life income option for payout of the $250,000 account balance in his non-qualified variable annuity, with payments to be made annually. James has a cost basis of $75,000 and his life expectancy is 15 years. How much of each annual payment may James exclude from his taxable income each year?

$5,000 Once a contract is annuitized, the portion of each annuity payment attributable to the cost basis is excluded from tax. The exclusion amount is the aggregate cost basis ($75,000) divided by life expectancy (15 years) = $5,000 per year. Thus, each year James will exclude $5,000 as his cost basis and must report as taxable income any amount he receives over that amount.

All of the following statements about redemption of units during the accumulation period of a non-qualified variable annuity are correct EXCEPT it:

is subject to First-In-First-Out (FIFO) accounting Withdrawals from annuity contracts prior to annuitization are subject to LIFO accounting. Premiums paid in are non-deductible. These are the first dollars in. Earnings, if any, build tax-deferred. These are the last dollars in and when withdrawals are made, these come out first and are taxable as ordinary income. If the account has $10,000 cost basis (non-deductible premiums paid into the contract with after-tax dollars) and the total value is now $15,000 and the customer redeems the contract prior to annuitization, then the owner will be taxed on the first $5,000 of any withdrawal at ordinary income tax rates and the next $10,000 withdrawn is a non-taxable return of capital (after-tax dollars). If the owner is under age 59½, an additional 10% premature withdrawal penalty tax applies to the $5,000 taxable portion of the withdrawal.

Which of the following statements are TRUE regarding tax rules for payouts from non-qualified variable annuities? I Earnings are tax deferred until payout II Earnings are taxed at the capital gains rate III The cost basis for the annuity is the amount of premiums paid IV The cost basis for the annuity is zero

I and III The premiums paid into the separate account for a non-qualified annuity are not deductible. These are "post-tax" dollars and represent the customer's cost basis in the contract - making Choice III correct and Choice IV incorrect. Both earnings and capital gains in the separate account are reinvested during the accumulation phase and build tax deferred until payout. These are "pre-tax" dollars. Thus, Choice I is correct. At payout, only the portion of each payment attributable to the "build-up" (pre-tax dollars) is now taxable at ordinary income tax rates (not at capital gains rates, making Choice II incorrect). The cost basis (premiums paid into the contract) is a tax-free return of capital invested (since these are post-tax dollars).

Which statements are true about non-qualified variable annuities? I Contributions to the separate account are tax deductible II Contributions to the separate account are not tax deductible III Earnings in the separate account build tax-deferred IV Earnings in the separate account are taxable each year

II and III There is no tax deduction for contributions made to a non-qualified variable annuity contract. The major advantage is the tax-deferred build-up of earnings in the separate account. When distributions commence, the portion of the distribution attributable to the build-up is taxable (these are pre-tax dollars) while the portion attributable to the original investment (these are post-tax dollars) is the cost basis for tax purposes and is returned without any tax due.

Which statements are true about retirement plans? I Payments into a non-qualified plan are made with pre-tax dollars II Payments into a non-qualified plan are made with post-tax dollars III Payments into a non-qualified plan are tax-deductible IV Payments into a non-qualified plan are not tax deductible

II and IV A qualified retirement plan is one that "qualifies" for favorable tax treatment under the tax code. Annual contributions to qualified plans are limited in amount and are tax-deductible. Thus, these contributions are made with "pre-tax" dollars. Earnings in the account build tax-deferred. When distributions are taken at retirement age (59 1/2 or later), the entire distribution is taxable, because none of the dollars in the account were ever taxed. A non-qualified retirement plan is one that does not qualify for favorable tax treatment under the tax code. Annual contributions to non-qualified plans are not subject to limitations and are not deductible. Thus, these contributions are made with "post-tax" dollars. Earnings in the account build tax-deferred. When distributions are taken at retirement age (59 1/2 or later), only the portion of the distribution attributable to the "build-up" is taxable (these dollars were never taxed and are "pre-tax" dollars). The portion of the distribution that is attributable to the original investment dollars is a return of capital that is not taxable (since there was no deduction for the investment, these are "post- tax" dollars).

A customer owns a variable annuity and surrenders the contract for a lump sum on early retirement at age 55. The contract is still in the accumulation phase at the time. Based on these facts, which of the following statements are correct? I The entire dollar amount of the lump sum distribution is included in gross income II Since surrender occurs before age 59 1/2, while the contract owner is in good health, a 10% penalty tax will be imposed on any taxable income III If the customer waits until after age 59 1/2, the accumulated investment income would escape income taxes IV The 10% penalty is not imposed after age 59 1/2

II and IV The entire amount of a lump sum distribution is not taxable income. Only the portion of the distribution that is attributable to the tax-deferred "build-up" is taxable (these are pre-tax dollars). The portion of the distribution attributable to the original investment consists of post-tax dollars (there was no deduction for the contribution), so these are returned without tax due. Thus, Choice I is incorrect. Taxable income taken before age 59 1/2 is subject to the 10% penalty tax. Thus, Choice II is correct. Distributions taken at age 59 1/2 or later are subject to ordinary income tax, but not to the 10% penalty tax. Thus, Choice IV is correct. Accumulated tax-deferred investment income does not escape taxation, no matter when withdrawn, thus Choice III is incorrect.

Which of the following statements concerning the federal income tax treatment of a non-qualified variable annuity is correct?

The annuity owner may not deduct premium payments With a non-qualified variable annuity, premium payments are not deductible, so Choice D is correct. During the accumulation period, the investment earnings are not subject to income tax. One of the major advantages of fixed and variable annuities is the tax-deferred "build-up" of investment earnings. Thus, Choice C is incorrect. When distributions are taken upon annuitization, the payments are now taxable at ordinary income tax rates. Note, however, that only the portion of the annuity payment attributable to the "build-up" is taxable (these dollars were never taxed). The portion of the annuity payment that is attributable to the original investment dollars is a return of capital that is not taxable (since there was no deduction for the investment, these are "already taxed" dollars). Thus, Choice B is incorrect. If the owner surrenders the variable annuity prior to annuitization for a lump sum payment, the amount the owner receives in excess of the owner's cost basis (which is the total of premiums paid) is subject to federal income tax. The cost basis (premium paid) is returned to the owner without tax due, since these are "already taxed" dollars. Thus, Choice A is incorrect.

Joe purchased a variable annuity for $100,000, but he died at age 52 before the annuity reached the payment stage. At that time, the NAV is $140,000 and this death benefit is paid to Joe's younger sister. What is the tax consequence to the sister of receiving this death benefit?

The sister must report $40,000 of the death benefit as ordinary income Remember that the "build-up" in the separate account has not yet been taxed - and when funds are distributed from the account, someone has to pay the income tax on the build-up portion. In this case, the cost basis is $100,000 and the build-up is another $40,000. When the $140,000 is paid to the sister, the sister must report the $40,000 build-up amount as ordinary income. There is no 10% penalty tax on a death benefit. Also note that the $140,000 amount is also included in Joe's estate for estate tax purposes, but this is not asked in the question.