Unit 24
A 57-year-old client has $100,000 in a nonqualified variable annuity and $100,000 in a mutual fund with a dividend reinvestment plan. Coincidently, each was purchased 10 years ago with a deposit of $50,000. If the client needs $50,000 to use as a down payment for a vacation home, which would have the most severe tax consequences? A) The variable annuity B) The mutual fund C) The same tax consequences for both D) Not enough information to tell
A) The variable annuity There are several differences involved here. First of all, withdrawals from a variable annuity are treated on a last-in, first-out (LIFO) basis. That is, the earnings are considered to be withdrawn first. In that case, all $50,000 taken from the variable annuity are taxed as ordinary income. In addition, because the client is not yet 59½, the 10% tax penalty is tacked on. The mutual funds are part of a dividend reinvestment program, which means that a good portion of the $50,000 in gain has already been taxed; in any event, there is no early-withdrawal tax penalty. Finally, profits from the sale of mutual fund shares held this long would be taxed at the long-term gains rate, which is always lower than the rate for ordinary income.
An owner of an equity index annuity would be wise to use the high-water crediting method if the underlying index was expected to A) change its objective. B) be volatile. C) remain steady. D) decline.
B) be volatile. An advantage of the high-water crediting method is that the interest is calculated using the highest value of the index during the term. Therefore, in a volatile market, where prices are going up and down, it picks up the highest price.
When discussing the purchase of a scheduled premium variable life insurance policy with a client, it would be correct to state that A) premiums will vary based upon performance of the separate account B) by surrendering the policy, its cash value may be obtained C) you will receive a statement of your death benefit no less frequently than semiannually D) if a policy loan exceeds the policy cash value, the deficiency must be remedied within 10 business days to keep the policy from lapsing
B) by surrendering the policy, its cash value may be obtained Surrender of the contract requires the insurance company to pay out its cash value. The death benefit is calculated annually (not semiannually) with the cash value being figured monthly. There is no time requirement to remedy a cash value deficiency. Scheduled premium means fixed premium, one that does not change. It is the cash value and the death benefit that will be affected by the performance of the separate account.
Among the reasons to consider investing in a variable annuity would be all of the following except A) a guaranteed death benefit for death before annuitization B) capital gains treatment on any realized gains upon withdrawal C) avoiding probate upon the death of the investor D) basically, no limit on the amount that can be contributed
B) capital gains treatment on any realized gains upon withdrawal In return for granting tax deferral on all gains in the account, the IRS taxes everything over the investor's cost basis as ordinary income. There is never a capital gain with a variable annuity. Some insurance companies will place a limit on the amount that may be invested, especially for older clients, but unlike IRS rules on retirement plans, this is strictly a company-by-company decision, not a law. Variable annuities are generally sold with a death benefit provision guaranteeing that the beneficiary will receive the higher of the amount invested or the current value of the account. Because there is a specifically named beneficiary, annuities do not go through the probate process.
All of the following terms are found in a typical equity index contract except A) participation rate. B) inflation rate. C) cap rate. D) settlement options.
B) inflation rate. Equity-indexed annuities (EIAs), or just plain index annuities, have a participation rate and a cap rate. They, like all annuities, offer different settlement options. However, there is no such thing as an inflation rate.
A client purchased an index annuity from you three years ago and made an initial deposit of $100,000. The contract calls for a 90% participation rate with a 15% cap. The index had a return of +20% in the first year, -5% the second year, and +10% the third year. The investor's current value is approximately A) $128,620. B) $117,829. C) $125,350. D) $126,500.
C) $125,350. In the first year, the index gained 20%. With a 90% participation rate, the investor might have earned 18% but was limited by the 15% cap. So after one year, the value was $115,000. In the second year, the index lost money. However, with an index annuity, there are never any reductions in a down market. So the account remained at $115,000. In the third year, the investor received 90% of the 10% growth, and that increased the account value to $125,350. This resulted in an overall gain of 25.35%, or an average return of almost 8.5% per year.
In a scheduled premium variable life insurance policy, which of the following are guaranteed? A) The right to exchange the policy for a permanent form of insurance with comparable benefits within the first 24 months of issue, as long as the insured passes a new physical examination B) The ability to borrow a maximum of 75% of the cash value once the policy has been in force at least 3 years C) A minimum death benefit D) A minimum cash value
C) A minimum death benefit In a variable life insurance policy, a minimum death benefit is guaranteed, but no cash value is guaranteed. There is a contract exchange privilege during the first 24 months allowing the conversion of the variable policy to a comparable form of permanent insurance, but no physical is required. The 75% cash value loan is a minimum, not a maximum, and applies after the 3rd year of coverage.
Concerning index annuities and their method of crediting interest, which of the following is true? A) Annual reset offers the best return regardless of market fluctuations. B) On average, annual reset has a higher participation rate than point to point. C) High-water mark with look back offers the best return during periods of high volatility. D) Point to point offers the best return when the market has had a single drastic decline during the period.
C) High-water mark with look back offers the best return during periods of high volatility.
Among the reasons why deferred variable annuities might not be a suitable investment for seniors are all of the following except A) improper subaccount selection B) potential capital fluctuation C) potential inflation protection D) surrender charges
C) potential inflation protection Variable annuities do offer potential inflation protection due to their participation in the equity market. The tradeoff is potential capital fluctuation, particularly if the portfolio selected is too aggressive. In addition, they typically carry high surrender charges.
A customer in his 20s, who is not risk averse, is in the market for life insurance. His main worry is that what looks like a generous death benefit today may not be sufficient for a beneficiary 40 or 50 years from now. An investment adviser representative might consider recommending A) whole life insurance with the option of purchasing additional coverage. B) term life insurance. C) scheduled premium variable life insurance. D) an aggressive, long-term strategy of investment in small-cap stocks.
C) scheduled premium variable life insurance Variable life insurance has the advantage of offering possible inflation protection for the death benefit. The insured assumes investment risk for this benefit and pays a fixed scheduled premium for the life of his contract. Term life insurance is usually a fixed amount, and the premium increases as the insured ages. This would not meet the customer's need for an increasing death benefit. Buying a whole life policy with a rider permitting the purchase of additional insurance means a higher premium now for the policy for the rider and then, as the insured is older, higher premiums for the new insurance. That could work, but the advantage to the variable life policy is that there is the opportunity for the death benefit to grow while the premiums remain level. Some would recommend the aggressive portfolio strategy, but the question tells us the customer is looking for life insurance.
Your 55-year-old client owns a nonqualified variable annuity. He originally invested $50,000 4 years ago. The annuity has grown to a value of $60,000. If the client, who is in a 30% tax bracket, makes a random withdrawal of $15,000, what will he pay to the IRS? A) $0.00 B) $4,500.00 C) $3,000.00 D) $4,000.00
D) $4,000.00 Because this is a nonqualified annuity (with no tax deduction), the client pays taxes only on the growth portion or, in this case, $10,000. The tax on this amount is $3,000. However, because the client is not yet age 59½ when making the withdrawal, he also pays a 10% tax penalty, or $1,000. (10% * 10,000 taxable amount) This makes a total of $4,000 tax and tax penalty paid on the random withdrawal.
A variable annuity annuitant bears all of the following risks except A) market risk B) interest rate risk C) inflation risk D) mortality risk
D) mortality risk The insurance company issuing the variable annuity bears mortality risk, or the danger that some annuitants will live to surpass their average life expectancy. The primary risk to the investor in a variable annuity is market risk. Although variable annuities attempt to keep up with inflation, there is no assurance that the performance of the separate account, after expenses, will do so. To the extent that the selected subaccounts contain fixed income securities, there will also be interest rate risk.
