Variable Annuities

The purchaser of a variable annuity bears which of the following risks? I Interest rate risk II Expense risk III Mortality risk IV Investment risk A I and IV only B II and III only C I, II, III D I, II, III, IV

The best answer is A. Both mortality risk (the risk that the annuitant lives longer than expected) and expense risk (the risk that expenses of running the separate account are higher than expected) are borne by the issuer of a variable annuity contract. The customer assumes the investment risk, since the annuity payment varies with the performance of the securities funding the separate account. With any investment, customers assume legislative risk and interest rate risk. Legislative risk for a variable annuity contract would be Congress changing the tax law. Interest rate risk is inherent in any product that gives the holder a stream of payments - if market interest rates rise, the value of the stream of payments decreases.

If the actual interest rate earned in the separate account underlying a variable annuity contract is lower than the "AIR," the annuity payment: A will increase B will decrease C is unaffected D is fixed at a minimum amount

The best answer is B. The "AIR" is the "Assumed Interest Rate." This is used as an illustration of the annuity payment that will be received if the separate account grows at the AIR. If the assets grow at an interest rate that is higher than the AIR, then the annuity payment will increase. Conversely, if the assets grow at an interest rate that is lower than the AIR, then the annuity payment will decrease.

Upon annuitization, a customer's insurer calculated the assumed interest rate (AIR) of his annuity as 5 percent. The account earned 6 percent after the first year. The customer's next payout amount will: A increase B decrease C remain unchanged D increase by the changes in the CPI

The best answer is A. Payout amounts will change depending upon the actual earnings of the separate account assets. AIR - Assumed Interest Rate - is the assumed investment return needed to maintain a level monthly payment. If the actual investment return exceeds AIR (as in this example), then the monthly payment will increase. If actual investment return is less than the AIR, then the monthly payment will decrease.

A customer, age 50, invests $50,000 in a variable annuity. The account has grown in value to $60,000 and at age 55, the customer takes a lump sum withdrawal of $15,000. Which statement is TRUE about the taxation of the withdrawal? A The entire $15,000 withdrawal is subject to regular income tax plus a 10% penalty tax B $10,000 of the withdrawal is subject to regular income tax plus a 10% penalty tax; $5,000 of the withdrawal is not taxable C $10,000 of the withdrawal is subject to regular income tax only; $5,000 of the withdrawal is not taxable D The entire $15,000 withdrawal is not taxable

The best answer is B. Lump-sum distributions from variable annuity contracts are taxed on a LIFO (Last in; First out) basis. The first-in dollars are the non-deductible (already taxed) premium payments (capital contribution). The earnings in the account then build tax-deferred. These are the last-in dollars that have not been taxed. When a distribution is taken, the first dollars out represent the untaxed build-up. The last dollars out represent the already taxed premium payments. This customer withdrew $15,000. The first $10,000 of the distribution represents the build-up and this is taxable at ordinary income tax rates, plus a 10% penalty tax is due because the customer is under age 59 1/2. The remaining $5,000 of the distribution represents the return of capital (the "already taxed" investment dollars).

A 50-year old man owns a non-qualified variable annuity contract that has appreciated substantially over the years. He wishes to annuitize the account for additional income using IRS Rule 72t. How will the first payment be taxed? A 100% taxable ordinary income B 100% non-taxable cost basis C Part ordinary income and part cost basis D 10% penalty tax applied because the client is under age 59 1/2

The best answer is C. Instead of taking a lump sum distribution, the owner of a variable annuity contract can "annuitize" and receive annuity payments for life. Each payment has 2 components - an earnings portion that is taxable and a return of capital portion (cost basis) that is not taxable. The non-taxable portion represents the return of the original investment that was made with "after tax" dollars. IRS Rule 72t gives a way for payments to be taken from the annuity prior to age 59 1/2 without the 10% penalty tax being applied. Rule 72t basically requires that annual payments deplete the account over that individual's expected life (the IRS has 3 approved methods for this). The rule also requires that a minimum of 5 annual "Substantially Equal Periodic Payments" (SEPPs) be taken, but that payments must continue until at least age 59 1/2.

Which statement is TRUE when a non-qualified variable annuity is annuitized prior to age 59 1/2 under the provisions of IRS Rule 72t? A 100% of each payment will be taxable at ordinary income rates B 100% of each payment will be non-taxable C Each payment received will be partially taxable but the 10% penalty tax will not be applied D Each payment received will be partially taxable and the 10% penalty tax will be applied

The best answer is C. Instead of taking a lump sum distribution, the owner of a variable annuity contract can "annuitize" and receive annuity payments for life. Each payment has 2 components - an earnings portion that is taxable and a return of capital portion (cost basis) that is not taxable. The non-taxable portion represents the return of the original investment that was made with "after tax" dollars. IRS Rule 72t gives a way for payments to be taken from the annuity prior to age 59 1/2 without the 10% penalty tax being applied. Rule 72t basically requires that annual payments deplete the account over that individual's expected life (the IRS has 3 approved methods for this). The rule also requires that a minimum of 5 annual "Substantially Equal Periodic Payments" (SEPPs) be taken, but that payments must continue until at least age 59 1/2.

All of the following are true about variable annuities EXCEPT: A salespersons must register with both FINRA and the State Insurance Commission to sell variable annuities B annuity payments may not be reduced due to increased expenses experienced by the insurance company C variable annuities are considered to be securities regulated by the Investment Company Act of 1940 D Investment risk is carried by the issuer of the annuity

The best answer is D. To sell variable annuities, both an insurance and a securities registration are required. The issuer gives an expense guarantee, limiting the amount of expenses that the issuer can charge against the contract. Variable annuities are considered to be securities because the purchaser bears the investment risk. Investment risk in a variable annuity is carried by the purchaser, not the issuer of the contract.

A customer invests $30,000 in a variable annuity contract. Over the years, the contract grows to $60,000 in value. At age 65, the customer takes a $40,000 lump sum distribution from the contract. The tax consequence is: A $40,000 non-taxable income B $40,000 taxable income C $10,000 taxable income; $30,000 non-taxable return of capital D $30,000 taxable income; $10,000 non-taxable return of capital

The best answer is D. Variable annuity distributions are taxed LIFO (Last In; First Out). The "Last In" dollars are the tax-deferred build up in the separate account. These come out first and are taxable. Any distribution beyond this amount is a tax free return of invested capital (there is no tax deduction for variable annuity contributions). Because $40,000 was distributed, $30,000 represents the build-up (taxable) and the remaining $10,000 is a tax-free return of capital.

The "death benefit" associated with a variable annuity contract: I applies during the accumulation phase II applies during the annuity phase III prior to annuitization, the insurance company will pay to a beneficiary, at least the amount invested in the contract IV after annuitization, the insurance company will pay for the insured's burial expenses A I and III B I and IV C II and III D II and IV

The best answer is A. The "death benefit" of a variable annuity contract is not really much of one. If the contract holder dies prior to annuitization, the insurance company pays the greater of current NAV or the amount invested to a beneficiary. If the contract holder dies after annuitization, there is no more "death benefit."

A customer invests $50,000 in a non-qualified variable annuity. Over the years, it has grown in value to $110,000. The customer's cost basis in the annuity contract is: A 0 B $50,000 C $60,000 D $110,000

The best answer is B. The customer's cost basis in a non-qualified annuity is the amount contributed - these are dollars that are after-tax (no tax deduction is allowed for these). The build-up over the cost basis represents the dollars that were never taxed. When distributions commence, only the portion attributable to the build-up is taxable.