Series 7 Unit 9

A customer has a nonqualified variable annuity. Once the contract is annuitized, monthly payments to the customer are A) 100% taxable. B) 100% tax free. C) partially a tax-free return of capital and partially taxable. D) 100% tax deferred.

C The investor has already paid tax on the contributions, but the earnings have grown tax deferred. When the annuitization option is selected, each payment represents both capital and earnings. The money paid in will be returned tax free, but the earnings portion will be taxed as ordinary income.

qualified annuities

everything is taxable with distribution the cost basis is 0 penalty for distributions unless with exception

If your customer invests in a variable annuity and chooses to annuitize at age 65, which of the following statements are true? She will receive the annuity's entire value in a lump-sum payment. She may choose to receive monthly payments for the rest of her life. The accumulation unit's value is used to calculate the total value of the account. The annuity unit's value represents a guaranteed return.

2 and 3 When a variable contract is annuitized (distributed in regular payments, not as a lump sum), the number of accumulation units is multiplied by the unit value to arrive at the account's current value. An annuity factor is taken from the annuity table, which considers, for example, the investor's sex and age. This factor is used to establish the dollar amount of the first annuity payment. Future annuity payments will vary according to the separate account's performance.

On April 15, 2016, your client purchased a variable life insurance policy with a death benefit of $450,000. The November 2019 statement showed a cash value of $28,000. If the client wanted to borrow as much as possible, the insurance company would have to allow a loan of at least A) $21,000. B) $28,000. C) $14,000. D) $25,200.

A Once a variable life policy is in force for a minimum of three years (this one is a bit longer than that), there is a requirement to make the loan provision available. At the three-year mark, that minimum becomes 75% of the computed cash value. Seventy-five percent of cash value of $28,000 is $21,000.

Your 65-year-old client owns a nonqualified variable annuity. He originally invested $29,000 four years ago, and it now has a value of $39,000. If your client, who is in the 28% tax bracket, makes a lump-sum withdrawal of $15,000, what tax liability results from the withdrawal? A) $2,800 B) $4,200 C) $0 D) $3,800

A This annuity is nonqualified, which means the client has paid for it with after-tax dollars and has a basis equal to the original $29,000 investment. Consequently, the client pays taxes only on the growth portion of the withdrawal ($10,000). The tax on this is $2,800 ($10,000 × 28%). Because the client is older than age 59½, she does not pay 10% premature distribution penalty tax.

A registered representative with ABC Securities has recently become aware of a new variable annuity. As tax time is approaching, the representative decides to recommend the variable annuity to all of her customers as an attractive addition to their portfolios. The representative should recommend the variable annuity to all of her clients because the tax advantage almost always results in a greater return. recommend the variable annuity to those clients whose needs and objectives match the investment. recommend the variable annuity to all of her clients because of the performance potential of the subaccounts. not recommend the investment to all of her clients in spite of the tax advantages and additional features. A) I and III B) II and IV C) II and III D) I and IV

B Recommendations may be made only when it is suitable for the customer's needs. Therefore, she would not recommend the variable annuity to all because some of them may not be able to benefit from those tax advantages.

A 38-year-old investor places $25,000 into a qualified single premium deferred variable annuity. Twenty-two years later, with the account valued at $72,000, the investor surrenders the policy. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $11,750. B) $18,000. C) $16,450. D) $25,200.

B Because this is a qualified annuity, the entire withdrawal is taxable. The surrender value of $72,000 has a cost basis of $0.00. That $72,000 is taxed at the marginal rate of 25%. Because the investor is older than 59½ (38 + 22 = 60), there is no additional 10% penalty tax. Effectively, this is a 25% tax on $72,000.

Which of the following statements regarding variable annuities are true? The number of accumulation units is always fixed throughout the accumulation period. The number of accumulation units can rise during the accumulation period. The number of annuity units is fixed at the time of annuitization. The number of annuity units rises once annuitization begins. A) I and IV B) II and III C) I and III D) II and IV

B The number of variable annuity accumulation units can rise during the accumulation period when additional units are being purchased. When a variable annuity contract is annuitized, the number of annuity units is fixed.

An important feature of scheduled premium variable life insurance policies is that A) better than expected performance of the separate account can lead to reduced premiums. B) the death benefit can never fall below the guaranteed minimum amount. C) the cash value can never fall below the guaranteed minimum amount. D) purchasers must understand that there are no guarantees with these policies.

B cheduled (fixed) premium variable life always has a guaranteed death benefit. Cash values cannot be guaranteed, only the death benefit. Better than expected performance of the separate account will lead to increased cash values, but it will not affect the premiums.

Although there are general suitability rules that always apply, FINRA's Rule 2330 on variable annuity suitability specifies that, to be considered suitable, there is a reasonable basis to believe that the customer has been informed—in general terms—of various features of A) immediate variable annuities. B) single premium variable annuities. C) deferred variable annuities. D) deferred annuities of all types.

C FINRA's primary suitability concern is with deferred variable annuities. That does not mean there are no requirements for being careful with the others, it is just that most of the violations have involved the deferred VA.

A customer has an investment objective of keeping pace with inflation while assuming moderate risk. Which of the following recommendations would best meet the customer profile? A) Variable life insurance policy B) IPO C) Variable annuity D) Money market fund

C Insurance companies introduced the variable annuity as an opportunity to keep pace with inflation. For this potential advantage, the investor, rather than the insurance company, assumes the investment risk. A variable life insurance policy should be purchased primarily for its insurance features, not its investment features.

An investor begins a periodic payment deferred variable annuity purchase program. One respect in which this differs from purchasing a mutual fund is that A) the variable annuity contract will generally have lower expenses than the mutual fund. B) there is a minimum guaranteed return with the variable annuity, while there are no guarantees with the mutual fund. C) the investor in the variable annuity contract reports no taxable consequences during the accumulation period. D) the mutual fund will generally have a surrender charge for early withdrawal and variable annuities only charge for surrender when annuitizing.

C One of the features of annuities is the tax deferral of all earnings until the money is withdrawn. Mutual fund distributions are taxable when received. On the other hand, when the annuity accumulation is withdrawn, everything above the cost basis is taxed as ordinary income (10% penalty if younger than 59½)—there is never any capital gains treatment with annuities. Variable annuities invariably have higher expense ratios than mutual funds with similar portfolios. Surrender charges are found with annuities. Do not confuse those with the conditional deferred sales charge (CDSC) applied to certain mutual fund share classes.

The Investment Company Act of 1940 has a number of rules relating to variable life insurance policies. All of these are included except A) the minimum cash value loan provision after 3 years. B) the variable life contract exchange provision is good for a minimum of 24 months. C) the maximum allowable sales charge is 8.5% of the premium payment. D) the free-look provision for 45 days after execution of the application.

C The 8.5% maximum sales charge is the FINRA rule relating to mutual funds. The Investment Company Act of 1940 requires that sales charges on a fixed-premium variable life contract may not exceed 9% of the payments to be made over the life of the contract. The contract's life, for purposes of this charge, is a maximum of 20 years.

In a variable life annuity with 10-year period certain, a contract holder receives A) fixed payments for 10 years, followed by variable payments for life. B) variable payments for 10 years, followed by fixed payments for life. C) a minimum of 10 years of variable payments, followed by additional variable payments for life. D) 10 years of variable payments.

C The owner of a life annuity with 10-year period certain will receive payments for life, subject to a minimum of 10 years. If the contract holder dies before the period expires, the remaining payments are made to the beneficiary. For example, if a life annuity with a 10-year period certain contract holder died after five years, payments would continue for five more years to the beneficiary and then stop.

Which of the following must be registered as investment companies under the Investment Company Act of 1940? Closed-end investment companies Separate accounts of insurance companies offering variable products Variable annuity contracts Variable life insurance policies A) I and IV B) II and III C) I and II D) III and IV

C Under the Investment Company Act of 1940, face amount certificate companies, unit investment trusts, open- and closed-end management companies, and separate accounts of insurance companies used to fund variable annuity and variable life contracts must register with the SEC as investment companies. Note that the separate account is registered as an investment company, not the variable contract.

Many life insurance companies offer variable products. Determining benefits usually depends on the actual performance of the selected separate account subaccount(s) compare to an assumed interest rate (AIR). Which of the following statements reflects that determination? Actual performance compared to the AIR affects the cash value of a variable life insurance policy Actual performance compared to the AIR affects the death benefit of a variable life insurance policy Actual performance compared to the AIR affects the value of an accumulation unit of a variable annuity Actual performance compared to the AIR affects the value of an annuity unit of a variable annuity A) II and III B) I and IV C) II and IV D) I and III

C When the actual performance of the separate account exceeds the AIR, the death benefit of a variable life insurance policy will increase. When the performance is less than the AIR, the death benefit reduces, but never below the guaranteed minimum. There is no assumed interest rate for the cash value. That is, the insurance company makes no projections as to its growth. With variable annuities, it is the annuity unit where the performance versus the AIR is important. In order to set up lifetime payments, the insurance company makes certain assumptions about returns. If the returns are higher, the value of the annuity (payout) unit increases and vice-versa. During the accumulation period, there are no assumptions; the insurance company never projects how much the money will grow. LO 9.c

A 38-year-old investor places $25,000 into a qualified single premium deferred variable annuity. Twenty years later, with the account valued at $72,000, the investor surrenders the policy. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $16,450. B) $11,750. C) $18,000. D) $25,200.

D Because this is a qualified annuity, the entire withdrawal is taxable. The surrender value of $72,000 has a cost basis of $0.00. That $72,000 is taxed at the marginal rate of 25%. Furthermore, because the investor is younger than 59½ (38 + 20 = 58), there is the additional 10% penalty tax. Effectively, this is a 35% tax on $72,000.

Your customer owns a variable annuity contract. The assumed interest rate (AIR) stated in the contract is 5%. In January, the realized rate of return in the separate account was 7%, and she received a check in February based on this return for $200. In February, the rate of return was 10%, and she received a check in March for $210. For her April check to be $210, what rate of return would the separate account have to earn in March? A) 7% B) 10% C) 3% D) 5%

D Each month's payout depends on the actual earnings compared to the AIR. If the actual rate of return equals the assumed interest rate, the check will stay the same. We don't compare one month's return to another's; we compare the actual to the assumed. If the actual is higher, the following month's check goes up. If the actual is lower, the following month's check goes down. And, as stated earlier, if the actual equals the assumed, there is no change

A customer has contributed $1,000 a year for 10 years to his tax-deferred nonqualified variable annuity. The value of the separate account is now $30,000. If the customer takes a withdrawal of $10,000, what are the tax consequences? A) Any tax due is deferred. B) Two-thirds of the withdrawal is taxable as ordinary income. C) There is no tax, as the withdrawal is considered return of capital. D) The entire $10,000 is taxable as ordinary income.

D The $30,000 contract value represents $10,000 of contributions and $20,000 of earnings. When a partial withdrawal is made from an annuity, the earnings are considered to be taken out first for tax purposes (or last-in, first-out). Therefore, ordinary income taxes will apply to the entire $10,000. In addition, if the customer is not at least 59½, there will be an additional tax penalty of 10%

A prospectus for a variable annuity contract must provide full and fair disclosure. is required by the Securities Act of 1933. must be filed with FINRA. must precede every sales presentation. A) I and III B) III and IV C) II and IV D) I and II

D A variable annuity is a security and must be registered with the SEC, not FINRA. As part of the registration requirements, a prospectus must be filed and distributed to prospective investors. The time of distribution of the prospectus can be before the sales presentation or at the same time as the presentation. It is incorrect to state that it must precede every sales presentation

Once a variable annuity has been annuitized A) the number of annuity units is fixed, and their value remains fixed. B) each annuity unit's value and the number of annuity units vary with time. C) each annuity unit's value is fixed, but the number of annuity units varies with time. D) each annuity unit's value varies with time, but the number of annuity units is fixed.

D During the payout period, payments are based on a fixed number of annuity units established when the contract was annuitized. The value of an annuity unit varies from month to month according to the performance of the separate account, in comparison to the assumed interest rate.

Bob Smith, who is in his 40s, has just become covered by an extremely generous defined benefit retirement plan at his company. He has decided he no longer needs his variable annuity for retirement purposes and wants to use the money for a trip to Africa. Over the past 10 years, he has invested $60,000 in the annuity, and its net value is now $80,000. If Bob should go ahead and surrender the annuity, the tax consequences will be A) capital gains tax on $60,000 and a $6,000 penalty. B) ordinary income tax on $60,000 and a $6,000 penalty. C) capital gains tax on $20,000 and a $2,000 penalty. D) ordinary income tax on $20,000 and a $2,000 penalty.

D If an annuity is cashed in, the growth and accumulation portion of its value ($20,000 in this case) is taxable as ordinary income. If the annuitant is under the age of 59½, he must also pay a 10% penalty on the growth withdrawn, a penalty of $2,000 in this case

Your client owns a variable annuity contract with an annual interest rate (AIR) of 4%. In March, the actual net return to the separate account was 8%. If this client is in the payout phase, how would her April payment compare to her March payment? A) It will stay the same. B) It will be lower. C) It cannot be determined until the April return is calculated. D) It will be higher.

D If the separate account of a variable annuity with an AIR of 4% had actual net earnings of 8% in March, the April payment will be higher than the March payment.

One of the features of variable insurance products is the ability to withdraw money from the policies. Which of the following statements is correct? A) Withdrawals from both are taxed on a LIFO basis. B) Withdrawals from variable annuities are taxed on a FIFO basis, while those from variable life are taxed on a LIFO basis. C) Withdrawals from both are taxed on a FIFO basis. D) Withdrawals from variable annuities are taxed on a LIFO basis, while those from variable life are taxed on a FIFO basis.

D One advantage to withdrawing cash value from a variable life insurance policy is that it receives FIFO treatment. That means there is no tax until the withdrawal reaches the cost basis (premiums paid) of the policy. With annuities, the taxation is LIFO. Therefore, the first money withdrawn is taxable. In addition, if the policyowner is not yet 59, the 10% penalty applies. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback.

You have a 70-year-old client who is in excellent health. Both parents lived into their late 90s and the client is concerned about outliving her money. What product guarantees that she will receive monthly payments for life, no matter how long that will be? A) Whole life insurance B) A 30-year term policy C) An index fund D) An annuity

D One of the unique characteristics of an annuity (variable or fixed) is that it guarantees monthly payments for the life of the annuitant. Life insurance provides a death benefit, but not income. An index fund carries no guarantees.

One of the specific concerns that the regulators have with variable annuities is sales personnel recommending that an investor switch from an existing contract to a new one. It would generally raise a "red flag" if the customer A) has had another deferred annuity exchange within the preceding 36 months. B) has had another deferred variable annuity exchange within the preceding 36 months. C) has had another deferred variable annuity exchange within the preceding 60 months. D) elects to make the exchange under the provisions of IRS Section 1035.

c FINRA Rule 2330 frowns on recommending the exchange of one deferred variable annuity for another within a period of 36 months. This only applies to deferred variable annuities. When an exchange takes place, it is generally under the provisions of IRS Section 1035 - no red flag raised there.

FINRA Rule 2330 deals with a member's responsibility in the sale of certain insurance company-based products. Specifically the concern is with A) immediate variable annuities. B) deferred variable annuities. C) variable life insurance. D) fixed-index annuities.

B

Variable annuities must be registered with the state banking commission. the state insurance commission. the Securities and Exchange Commission (SEC). FINRA. A) I and III B) II and III C) II and IV D) III and IV

B A variable annuity is a combination of two products: an insurance contract and a mutual fund. Therefore, variable annuities must be registered with the state insurance commission and the SEC.

One of your customers purchased a fixed premium variable life insurance policy five years ago. The face value of the policy is $2 million and the current cash value is $107,237. The customer calls you and asks about taking a policy loan. Although the exact details are in the prospectus, you know that the minimum amount that could be borrowed is A) $96,513.30. B) $80,427.75. C) $1,500,000.00. D) $107,237.00.

B Once a variable life insurance policy has been in effect for at least three years, the policy must allow for a policy loan equal to a minimum of 75% of the current cash value.

All of the following investment strategies offer either fully or partially tax-deductible contributions to individuals who meet eligibility requirements except A) variable annuities. B) IRAs. C) Keogh plans. D) defined contribution plans.

A Contributions to a nonqualified variable annuity are not tax deductible. Contributions to an IRA may be tax deductible, depending on the individual's earnings and participation in a company-sponsored qualified retirement plan.

An accumulation unit in a variable annuity contract is A) an accounting measure used to determine the contract owner's interest in the separate account. B) none of these. C) an accounting measure used to determine payments to the owner of the variable annuity. D) fixed in value until the holder retires.

A When money is deposited into the annuity, it is purchasing accumulation units.

All of the following statements regarding variable annuities are true except A) variable annuities offer the investor protection against capital loss. B) variable annuities may only be sold by registered representatives. C) variable annuities are classified as insurance products. D) insurance companies keep variable annuity funds in separate accounts from other insurance products.

A A variable annuity is both an insurance and a securities product. An annuitant assumes the investment risk of a variable annuity and is not protected by the insurance company from capital losses.

FINRA Rule 2330 states: no member or person associated with a member shall recommend to any customer the exchange of a deferred variable annuity unless such member or person associated with a member has a reasonable basis to believe the exchange suitable, taking into consideration whether A) the customer's health has declined since the purchase of the initial annuity. B) the customer is at least 59½ and will not be subject to the 10% tax penalty. C) the customer has had another deferred variable annuity exchange within the preceding 36 months. D) the new annuity has a higher assumed interest rate.

C FINRA Rule 2330 specifies the suitability conditions surrounding the recommended exchange of an existing deferred variable annuity contract for a new one. Included in the list of considerations is determining if the customer has made another variable annuity exchange within the previous 36 months. Unlike life insurance, where the insured's health is important, there are no health questions on an annuity application. It is safe to assume that any annuity exchange will be done under the provisions of Section 1035. This means there are no tax consequences. The assumed interest rate is for internal purposes; it is not a differentiator when deciding which variable contract to purchase.

A separate account will invest in a number of different securities. The separate account is not likely to invest in A) equity funds. B) money market funds. C) municipal bonds. D) corporate stock.

C The earnings on dollars invested into a variable annuity accumulate tax deferred, which is why variable annuities are popular products for retirement accumulation. As with all tax-deferred accounts, municipal bonds are not appropriate investments because interest earned on municipals is already tax exempt at the federal level.

A 38-year-old investor places $25,000 into a single premium qualified deferred variable annuity. Twenty years later, with the account valued at $72,000, the investor withdraws $50,000. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $12.500. B) $11,750. C) $16,450. D) $17,500.

D Because this is a qualified annuity, the entire withdrawal is taxable. In this case, it is all $50,000. That $50,000 is taxed at the marginal rate of 25%. Furthermore, because the investor is younger than 59½ (38 + 20 = 58), there is the additional 10% penalty tax. Effectively, this is a 35% tax on $50,000.

A 45-year-old client of yours receives an inheritance of $100,000 and wishes to invest it without having to worry about any taxes being due until she reaches age 68. In addition, the client would like to have some protection against inflation. Which of the following would be the most appropriate recommendation? A) A single premium variable life insurance policy B) An immediate variable annuity C) An S&P 500 index fund D) A single premium deferred variable annuity

D There are two benefits to the deferred variable annuity. The first is that taxes on all earnings are deferred until withdrawal. The second is that, if the proper separate account subaccounts are selected, there is potential inflation protection. An index fund will meet the second objective, but, even though index funds tend to be tax efficient, there will be certainly be dividend distributions from an S&P 500 index fund and possibly some capital gains as well. An immediate variable annuity begins payout immediately, so taxes start immediately as well. Variable life will never be an answer to a question unless the question describes a need for life insurance coverage—it cannot be sold strictly as an investment.