Unit 24
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) $4,000.00 B) $0.00 C) $3,000.00 D) $4,500.00
A) $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. This makes a total of $4,000 tax and tax penalty paid on the random withdrawal.
An agent has 4 clients who have purchased variable annuities, all of who are about to enter the annuitization phase. Client 1 purchased a single premium deferred annuity 20 years ago with a premium of $30,000. Client 2 purchased a single premium deferred annuity 10 years ago with a premium of $50,000. Client 3 purchased a periodic payment annuity 15 years ago and has made monthly premium payments totaling $60,000. Each of these 3 annuities has a current surrender value of $100,000. Client 4 just purchased an immediate annuity with a premium of $100,000. Assuming that all of these clients are of the same sex and the same age, when the annuity payout begins, which of the clients will receive the lowest amount of taxable income? A) Client 4 B) Client 3 C) Client 1 D) Client 2
A) Client 4 When it comes to taxation on annuitization, each payment consists of a combination of income and return of principal, how much of which depends on the exclusion ratio. In the case of Client 4, with an immediate annuity, it is unlikely that there is much in the way of income - almost all of the monthly payout will represent a nontaxable return of principal. Each of the other clients has tax-deferred income ranging from Client 1's $70,000 to Client 3's $40,000. When using the exclusion ratio to determine how much is income and how much is return of principal, Client 1 will have the greatest amount of taxable income followed by Client 2 and then Client 3.
Thirty years ago, an investor deposited $100,000 into a single premium deferred variable annuity. Today, the value of the accumulation units is $1.5 million. The investor is ready to annuitize and wishes to maximize monthly payments to be received. You would suggest which of the following settlement options? A) Straight life B) Life with 10 years certain C) Life with 20 years certain D) Joint and survivor
A) Straight life When one annuitizes, the amount of the annuity payment is highest when the annuitant takes the most risk (and the insurance company the least). Straight life payments end upon the death of the individual, and if that should be the following month, the insurance company keeps the rest of the money. In the period certain choices, the insurance company is "on the hook" for that number of years, even if the annuitant does not live that long.
A 57-year-old client has $100,000 in a non-qualified 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 tax consequences would be the same C) Not enough information to tell D) The mutual fund
A) The variable annuity There are several differences involved here. First of all, withdrawals from a variable annuity are treated on a LIFO basis. That is, the earnings are considered to be withdrawn first. In that case, all $50,000 taken from the VA are taxed as ordinary income. In addition, because the client is not yet 59 ½, there is the 10% tax penalty 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 and, 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, always lower than ordinary income.
A risk faced by many seniors is longevity risk. What security would be most appropriate to protect against that risk? A) Variable annuity B) Common stock C) Fixed annuity D) REIT
A) Variable annuity Longevity risk is the uncertainty that one will outlive his money. The only instrument that guarantees a payout for as long as one lives is an annuity. Because the question asks for a security, only the variable annuity is correct, otherwise the fixed annuity would also offer protection.
All of the following terms are found in a typical equity index contract except A) inflation rate. B) participation rate. C) cap rate. D) settlement options.
A) inflation rate. Equity-index 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.
Among the reasons why deferred variable annuities might not be a suitable investment for seniors are all of the following except A) potential inflation protection. B) potential capital fluctuation. C) surrender charges. D) improper sub-account selection.
A) 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, unlike mutual funds, they typically carry high surrender charges.
Variable annuities A) provide a guaranteed minimum annuity payout. B) may invest only in money market mutual funds. C) generally provide more security of principal than fixed annuities. D) may have 20 or more subaccount investment options.
A) provide a guaranteed minimum annuity payout. Some variable annuity separate accounts have 50 or more subaccounts to choose from. There are no guarantees as far as the amount of payout; that is why it is called a variable annuity.
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) scheduled premium variable life insurance. B) term life insurance. C) an aggressive, long-term strategy of investment in small-cap stocks. D) whole life insurance with the option of purchasing additional coverage.
A) 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.
Larry purchased a deferred annuity and, on his 65th birthday, annuitized the product under a life with 15-year certain option. His spouse, Linda, is the beneficiary. Which of the following statements is correct? A) Payments would be made to Larry until he is 80, then cease. B) Payments would be made to Larry as long as he lives, but should he die prior to reaching age 80, Linda will receive payments until Larry's 80th birthday. C) Payments would be made to Larry until his death, then to Linda for another 15 years. D) Payments would be made to Larry until he is 80, then to Linda for the remainder of her life.
B) Payments would be made to Larry as long as he lives, but should he die prior to reaching age 80, Linda will receive payments until Larry's 80th birthday. Larry selected the life with 15-year certain option. This pays Larry for his life, regardless of how long, but continues to pay his beneficiary (Linda) if he dies before the end of 15 years. That is the 15-year certain part.
An investor in a variable annuity will be purchasing A) annuity units. B) accumulation units. C) participation units. D) shares of the underlying sub-account.
B) accumulation units. Unlike a mutual fund, where the investment is into shares of the fund, when purchasing a variable annuity, the investor is acquiring accumulation units. Upon annuitization, those are converted into annuity units. The investor isn't directly purchasing shares in the underlying sub-account; the annuity company is doing that.
Among the reasons to consider investing in a variable annuity would be all of the following except A) basically, no limit on the amount that can be contributed B) capital gains treatment on any realized gains upon withdrawal C) a guaranteed death benefit for death before annuitization D) avoiding probate upon the death of the investor
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.
Among the special characteristics of a universal life insurance policy is A) early termination could lead to surrender charges B) the policy may be overfunded C) death benefits may increase above the initial face amount D) that policyowners may borrow against the cash value Explanation
B) the policy may be overfunded This question is looking for a feature found in universal life that is not generally found in other forms of life insurance, i.e, something special. In the case of universal life, the policyowner is permitted to pay in an amount in excess of the stated premiums (one of the reasons universal life is known as flexible premium life). The IRS puts limits on the amount of the overfunding before certain tax advantages are lost, but that is beyond the scope of the exam. Not only universal life, but variable life as well, has the possibility of increased death benefits. In fact, some whole life policies allow policy dividends to be used to increase the death benefit. Permanent forms of insurance policies, including whole life, universal life, and variable life, permit loans against the cash value. Therefore, being able to borrow against the cash value is nothing special. Many forms of life insurance have surrender charges for early termination.
A 54-year-old individual invests $25,000 into a nonqualified single premium deferred variable annuity. Five years later, with an account value of $35,000, the investor engages in a Section 1035 exchange into a variable annuity issued by a different insurance company. Four years later, with an account value of $50,000, the investor withdraws $20,000. The tax consequence of the withdrawal is A) $15,000 of ordinary income, $5,000 nontaxable return of principal. B) $20,000 of ordinary income plus a 10% penalty tax. C) $20,000 of ordinary income. D) $15,000 of ordinary income, $5,000 of long-term capital gain.
C) $20,000 of ordinary income. A partial withdrawal from a nonqualified annuity is taxed on a LIFO basis. That is, the last money in (assumed to be earnings), is the first money out. The cost basis is the original $25,000. The 1035 exchange merely carried that cost basis over and resulted in no current tax on the $10,000 of earnings. When $20,000 is withdrawn, all of it represents the earnings and that is taxed as ordinary income. There is never capital gains taxation on an annuity and there is no 10% penalty tax because this investor is older than 59½ at the time of the withdrawal.
Bob, age 60, has invested $17,000 in his nonqualified variable annuity over the years. The total value has reached $26,000. He wishes to withdraw $15,000 to send his son to college. What is his tax consequence on the withdrawal? A) The entire amount is taxable. B) The entire amount is nontaxable. C) $9,000 is taxable; $6,000 is nontaxable. D) $6,500 is nontaxable; $8,500 is taxable.
C) $9,000 is taxable; $6,000 is nontaxable. Because this is a nonqualified annuity, the $17,000 invested is after-tax dollars. Under the tax code, the taxable portion is considered to be withdrawn first in any lump-sum distribution. Therefore, the first dollars withdrawn are all taxable until the amount of withdrawal meets or exceeds the growth in the account. Because Bob is over 59½, there is no 10% tax penalty on his withdrawals.
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) you will receive a statement of your death benefit no less frequently than semiannually. C) by surrendering the policy, its cash value may be obtained. 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.
C) by surrendering the policy, its cash value may be obtained. Surrender of the contract requires the insurance company to pay out its cash value. Death benefit is adjusted annually. Cash value and perhaps death benefit will vary based on the performance of the selected separate account subaccount, but the fact that this is a scheduled premium policy means the premiums are fixed.
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.
When a variable annuity is annuitized A) the number of accumulation units redeemed each payment period varies based upon the performance of the separate account B) the number of annuity units redeemed each payment period varies based upon the performance of the separate account C) the number of annuity units redeemed each payment period remains constant D) the number of accumulation units redeemed each payment period remains constant
C) the number of annuity units redeemed each payment period remains constant Upon annuitization, the accumulation units are exchanged for annuity units. Based upon actuarial computations, the same number of annuity units is redeemed each payment period (usually monthly). The value of each unit is what varies.
One of the major financial decisions to be made by a family is the amount and type of life insurance to purchase. The form of insurance that offers flexible premiums without a fixed cash value is A) variable life. B) whole life. C) universal life D) term life.
C) universal life A unique feature of universal life is that the premiums are flexible. That is, if the client wishes to pay more or less than the target premium, that may be done. However, the nature of the universal life product is such that cash values can fluctuate. Cash values can fluctuate in variable life, but unless the policy is UVL (universal variable life), premiums are scheduled (fixed). Typically there are no cash values with term insurance and the premiums are fixed and whole life has both fixed premiums and guaranteed cash values.
The return that will be earned over the life of a fixed annuity A) is tied to an investment index such as the Standard & Poor's 500 B) is tied to a portfolio of common stocks selected by the annuity owner C) will always be at least equal to the guaranteed minimum specified in the contract D) may decrease over time due to the increase in surrender charges
C) will always be at least equal to the guaranteed minimum specified in the contract Fixed annuities are what the term implies—the return is fixed for the life of the contract. In some cases, a fixed annuity may actually pay more (but never less) than the guaranteed amount. This would be true if the insurance company earned what is called "excess interest."
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) $117,829 B) $126,500 C) $128,620 D) $125,350
D) $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 3rd 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.
When a customer wants income from an annuity and chooses the option of life with 20-year period certain, how will distributions be taxed? A) As ordinary income based on LIFO accounting B) As capital gains based on LIFO accounting C) As capital gains based on an exclusion ratio D) As ordinary income based on an exclusion ratio
D) As ordinary income based on an exclusion ratio Life with 20-year period certain is an annuitization option. When an annuity is annuitized, ordinary income taxes are paid based on an exclusion ratio (cost basis divided by expected return = how much of the distribution is a return of cost basis (the original principal invested), and not subject to income taxes). Testing note: Unless the question specifically mentions that the annuity is qualified, or gives you a clue, such as it is in a 403(b) plan, the annuity is always nonqualified.
An individual purchasing a flexible premium variable life contract should know which of the following? 1. Timing and amount of premiums generally are discretionary. 2. The death benefit will generally be higher than that of a comparable whole life policy. 3. The face amount is fixed at the beginning of the contract. 4. The performance of the separate account directly affects the policy's cash value. A) I and III B) II and III C) II and IV D) I and IV
D) I and IV A flexible premium policy allows the insured to determine the amount and timing of premium payments, provided minimums are met. Depending on the policy, the face amount (death benefit) is recalculated each year. It is intended that the death benefit receive some inflation protection, but this cannot be guaranteed. If separate account performance causes the cash value to drop below an amount necessary to maintain the policy in force, the policy lapses unless the requisite amount is received within 31 days.
The death benefit of a variable life policy must be calculated at least A) monthly B) weekly C) semiannually D) annually
D) annually The death benefit must be calculated annually and the cash value, monthly.
All of the following statements regarding scheduled premium variable life insurance are correct except A) the policyowner has the right to change the selection of subaccounts B) premiums are determined based on age and sex of the insured C) once selected, the policyowner may change payment modes D) better than anticipated results in the separate account could lead to a reduction in annual premium
D) better than anticipated results in the separate account could lead to a reduction in annual premium Scheduled (fixed) premium variable life premiums are fixed. It is universal life that has flexible premiums.
One way in which universal life and variable life are similar is that both A) have a fixed minimum cash value B) have flexible premiums C) are considered securities D) permit loans against the cash value
D) permit loans against the cash value As long as the policy has cash value, loans are permitted. Neither of these has a fixed minimum cash value, and only universal life has flexible premiums. Only variable life is considered a security.
The main benefit that scheduled premium variable life insurance has over whole life insurance is A) the availability of policy loans. B) an adjustable premium. C) a lower sales charge. D) the potential for a higher cash value and death benefit.
D) the potential for a higher cash value and death benefit. Premiums of variable life insurance policyholders are invested in the insurer's separate account. This allows the policyholder the opportunity (though there are no guarantees) to enjoy significant returns and substantially higher cash values than are obtainable through a whole life policy. Scheduled premium is just another way of saying fixed premium, a characteristic of whole life as well. Policy loans against the cash value are permitted in both policies with the cash value in the whole life being guaranteed. There is a maximum allowable sales charge on variable life policies (9% of total premiums paid over a 20-year period). The term sales charge is not used with whole life.