Retirement Accounts - Variable Annuities

A variable annuity can be exchanged for which of the following without a tax consequence? I Another variable annuity contract II A fixed annuity contract III A term life insurance policy IV A whole life insurance policy A I and II only B III and IV only C I and IV only D II and III only

A. Section 1035 of the tax code allows for so-called "like-kind" exchanges without taxes being due. The only valid reason to exchange a variable annuity contract is to get another variable annuity contract or a fixed annuity contract with better features or lower costs. Variable annuities are non-tax qualified and fixed annuities are also non-tax qualified - and one can exchange between them without tax due. If a variable annuity is exchanged for any insurance policy, this is NOT a like-kind exchange, and tax will be due on any appreciation in the separate account. The stance of the IRS is that the individual is only doing this to delay receipt of payments that are taxable (because the variable annuity payments would have been received earlier than the taxable death benefit.)

A mother, aged 60, wishes to withdraw monies from her variable annuity to pay for her son's college education. Which statement is TRUE regarding the taxation of the withdrawal? A The withdrawal is 100% taxable and is also subject to a 10% penalty tax B The withdrawal is 100% taxable C The withdrawal is partially taxable; and a partial tax free return of invested capital D The withdrawal is not subject to tax

C. Since this person is above age 59 1/2, any withdrawals from the retirement plan are not subject to the 10% penalty tax for a premature distribution. Since the contribution amount into the variable annuity contract was not tax deductible, this portion of the investment is returned without any tax consequence. Any earnings above this amount are taxed at the customer's bracket.

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

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

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.

A customer contributed $20,000 to a variable annuity contract. The account value has grown over the years and the NAV is now $35,000. The customer is now age 60, and takes a lump-sum distribution of $20,000 to pay for expenses. Which statement is TRUE? A The entire $20,000 distribution is not taxable B $5,000 of the distribution is taxable and $15,000 is not taxable C $15,000 of the distribution is taxable and $5,000 is not taxable D The entire $20,000 distribution is taxable

C. Variable annuity contributions are not tax-deductible. Earnings in the account build tax-deferred. When distributions are taken, tax is due on the portion that represents the tax-deferred build-up. The portion that represents the original contribution (already taxed dollars) is returned without any further tax due. If a lump-sum distribution is taken, the IRS uses LIFO (Last-In; First-Out) accounting. The Last-In Dollars are the tax-deferred build-up, so these are the First-Out dollars and they are 100% taxable! Any distribution above and beyond the build-up amount is a tax-free return of original capital. In this example, the customer contributed $20,000 and this has grown, tax-deferred, to $35,000. If a lump sum distribution of $20,000 is taken, the first dollars out are the $15,000 of never taxed build-up and this amount is taxable. The remaining $5,000 is a partial tax-free return of the original $20,000 investment (which was not tax deductible).

The owner of a variable annuity has which of the following rights? I Right to vote for distributions of income and capital gainsII Right to vote to change the separate account's investment objectiveIII Right to vote for the Board of TrusteesIV Right to vote for dissolution of the trust A I and II only B III and IV only C II, III, IV D I, II, III, IV

C. Distributions of dividends and capital gains are decided by the variable annuity's Board of Trustees. The unit holder can vote for the Board of Trustees and can vote to change the investment objective of the separate account. In addition, terminating the trust (a very unlikely event) would require unit holder approval as well.

All of the following are true statements about variable annuities EXCEPT: A the portfolio funding the separate account is professionally managed B the portfolio is invested in other management company shares C dividends and capital gains must be reinvested until annuitization occurs D investors get an interest rate guarantee

D. Variable annuity holders do not get an interest rate guarantee. The amount of any annuity depends on the performance of the separate account. Only fixed annuities give an interest rate guarantee. Variable annuity separate accounts are professionally managed; distributions must be reinvested; and the portfolio is invested in the shares of other management companies. (Finally, note that many variable annuity contracts offer an optional rider called a GMIB - Guaranteed Minimum Income Benefit - which guarantees that the separate account will grow at a minimum rate - but this requires the client to pay an additional fee each year. Because GMIB is not mentioned, there is no interest rate guarantee in this question.)

A client surrenders a variable annuity contract 5 years after purchase because of poor performance. Any surrender fee imposed: I increases sale proceeds II reduces sales proceeds III is deductible IV is not deductible A I and III B I and IV C II and III D II and IV

D. If a customer surrenders a variable annuity contract early (typically due to poor performance or a pressing financial need), then the customer's cost basis is the amount invested and the sale proceeds is the amount received on redemption. Any loss is deductible as an ordinary loss, but any portion of the loss due to the surrender fee is not deductible! If a customer invested $50,000 in a variable annuity and redeemed it when the NAV was $40,000, however the customer only received $37,000 because a $3,000 surrender fee was imposed, then of the $13,000 ordinary loss, $10,000 is deductible and $3,000 is non-deductible.

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

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.

Which statement is FALSE about a variable life policy? A The annual premium amount can be varied by the purchaser B The policy builds cash value that can be borrowed C It is a form of permanent insurance D The sale of the product requires the delivery of a prospectus to the purchaser

A. Variable life insurance has a fixed annual insurance premium, similar to whole life. Only "universal life" policies allow for "flexible" or adjustable premium payments where the purchaser can vary the premium paid. Part of the premium pays for the cost of the insurance and part of the premium is invested in a separate account that holds shares of a designated mutual fund (hence there is a prospectus delivery requirement). Variable life builds cash value like a whole life policy that the customer can borrow out. The amount of cash value depends on the performance of the mutual fund held in the separate account. Both whole life and variable life are forms of permanent insurance - as long as the premium is paid, the insurance continues in force. In contrast, term life is only good for the term of the policy and then must be renewed, typically at a higher premium because the purchaser is older.

A customer has invested $30,000 in a variable annuity contract. The current NAV is $50,000. The customer dies prematurely at the age of 50. What is the tax consequence? A The cost basis in the contract steps down to "$0" and all $50,000 is taxable at ordinary income tax rates B The cost basis in the contract steps up to $50,000 and no tax will be due C The cost basis in the contract is $30,000 and the $20,000 of build-up is taxable at ordinary income tax rates D The cost basis in the contract is $30,000 and the $20,000 of build-up is taxable at long-term capital gains tax rates

C. Even though assets are valued for estate tax purposes at the market value as of the date of death (commonly known as a "stepped up" basis), the assumption underlying this is that the asset was purchased with already-taxed dollars. The contributions made are the "already-taxed" dollars in a non-qualified annuity. The build-up represents never- taxed dollars. These are still taxable before they are included in the estate. (This estate tax treatment is true for qualified retirement accounts as well - upon death, the never-taxed assets in the account will be taxed at ordinary income tax rates before they are included in the taxable estate of the deceased individual).

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

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 of the following statements is (are) TRUE regarding variable annuity contracts? I The principal amount is guaranteed prior to annuitization by the insurance company that issues the contractII The principal amount is guaranteed after annuitization by the insurance company that issues the contractIII The contract holder loses control of the principal amount prior to annuitizationIV The contract holder loses control of the principal amount after annuitization A I and III only B II and IV only C IV only D I, II, III, IV

C. In a variable annuity contract, the principal amount is never guaranteed. The principal value may increase or decrease, depending on the performance of the separate account. The "investment risk" is borne by the contract holder, not the insurance company. Regarding the statement about the contract holder "losing control of the principal," this relates to the contract holder's ability to change the terms of the payout from the contract. Prior to annuitization, the contract holder is allowed to change his payout option, thus he has control over how the principal will be disbursed. However, once the contract is "annuitized," the contract holder cannot change the payout option - he or she loses control over the principal. (Please note that the term "losing control over the principal" does not refer to how the investment manager decides to invest the funds in the separate account.)

Which rollovers are permitted without tax due? I Exchange of one variable annuity contract for another variable annuity contract II Exchange of a life insurance contract for a variable annuity contract III Exchange of a variable annuity contract for a life insurance contract IV Exchange of a life insurance contract for another life insurance contract A I and II only B III and IV only C I, II, IV D I, II, III, IV

C. Section 1035 "tax-free" exchanges permit "like-for-like" exchanges without tax due. Thus, Choices I and IV are tax free. It also permits a life insurance policy to be exchanged for a variable annuity without tax due, making Choice II true. Of course, the IRS is happy about this because the taxable annuity payments will start earlier than the payment of the taxable death benefit.However, a variable annuity cannot be exchanged tax-free for an insurance policy under this tax rule, making Choice III false. If there is a gain in the separate account, it would be taxed upon exchange for a life insurance policy.

When a non-qualified variable annuity is annuitized prior to age 59 1/2 under the provisions of IRS Rule 72t, the initial payment is: A 100% taxable as ordinary income and the 10% penalty tax will be applied B 100% taxable as ordinary income but the 10% penalty tax is not applied C partially taxable as ordinary income with the 10% penalty tax applied and partially a non-taxable return of investment D partially taxable as ordinary income without the 10% penalty tax applied and partially a non-taxable return of investment

D. 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.

In order to recommend a variable annuity to a customer, the representative must inform the customer, in general terms, about any: I potential surrender period and surrender charge II potential tax penalty III mortality and expense fees IV charges for and features of enhanced riders A I and II only B III and IV only C I, II, III D I, II, III, IV

D. Consider this to be a learning question. To recommend a variable annuity, the representative must have a reasonable basis to believe that the customer has been informed, in general terms, about the material features of the variable annuity. These include the potential surrender period and surrender charge, potential tax penalty, mortality and expense fees, charges for and expenses of enhanced riders (a very popular rider, at a cost, is a GMIB - a Guaranteed Minimum Income Benefit), insurance and investment components and market risk.