Unit 24: Insurance-Based Products

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) be volatile. B) decline. C) change its objective. D) remain steady.

A) 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.

A fixed-premium variable life insurance contract offers a guaranteed maximum death benefit a guaranteed minimum death benefit a guaranteed cash value a cash value that fluctuates according to the contract's performance A) II and III B) I and III C) II and IV D) I and IV

C) II and IV A fixed-premium variable life contract offers a minimum death benefit and a variable death benefit over the minimum. Its cash value fluctuates with the performance of the separate account.

Which of the following would most likely put a limit on the amount of interest to be credited to an index annuity? A) The CDSC B) The participation rate C) The cap rate D) The annuity reset rate

C) The cap rate Many index annuities have a cap rate. That represents the maximum return that can be credited to the annuity, regardless of the performance of the index. It is what limits the amount credited. Yes, the participation rate does affect how much can be credited, but, if there is no cap, there is theoretically no limit on the earnings. This is an example where you have to select the answer that best matches the question. A cap is a limit.

Which of the following is indicative of the primary difference between variable life insurance and straight whole life insurance? A) Tax treatment of the death proceeds B) The way in which the cash values are invested C) Amount of insurance that can be issued D) Cost of the insurance

B) The way in which the cash values are invested Variable life insurance allows the policyowner to decide how the cash value is invested through a number of subaccounts. Death benefits from life insurance policies are always free of income tax regardless of the type of policy.

Which of the following is designed primarily as a retirement vehicle to help protect contract owners from a decline in purchasing power? A) Retirement income life insurance B) Variable annuities C) Flexible premium fixed annuity D) Life-paid-up-at-age-65 life insurance

B) Variable annuities The tradeoff with lack of guarantees is the potential to keep pace with inflation.

Which of the following is not considered to be an annuity purchase option? A) Single-premium immediate annuity B) Single-premium deferred annuity C) Periodic payment immediate annuity D) Periodic payment deferred annuity

C) Periodic payment immediate annuity An immediate annuity is one in which the payout begins immediately (generally within 30-60 days). As such, the concept of making purchases while receiving payout is illogical and is, therefore, not offered as an option.

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

A) partially a tax-free return of capital and partially taxable. 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.

Which of the following is not a type of life insurance policy? A) Variable annuity policy B) Universal life policy C) Endowment policy D) Term to 65 policy

A) Variable annuity policy Although a variable annuity may have a death benefit provision, it is not considered a life insurance policy. One key to that is, among other things, there is no health questionnaire when purchasing an annuity. Perhaps you have never heard of an endowment policy (it is not mentioned in the LEM). This type of situation may come up on the actual exam where one of the choices is something unfamiliar to you. Don't let that cause you to lose your focus. Annuities are issued by life insurance companies, but they are not life insurance policies, so select the correct answer and move on.

One of your customers would like to buy a life insurance policy that has no participation in the stock market, has no cash value, and provides coverage for 20 years. You should recommend A) a 20-year term life policy. B) a 20-pay life insurance policy. C) a whole life insurance policy. D) a variable annuity with a death benefit.

A) a 20-year term life policy. Term life insurance generally offers no cash value and is not tied to the stock market. Coverage terminates at the sooner of death or the stated term, which in this case is 20 years. Whole life, as the name implies, provides coverage for your entire life and does generate cash values. A 20-pay life policy offers lifetime coverage with the feature of premium payments for only 20 years (at a much higher rate than whole life). A variable annuity death benefit is not considered a life insurance policy. It simply pays back the greater of the annuity value or the total paid into the annuity when the policyholder dies.

All of the following terms are found in a typical equity index contract except A) cap rate. B) inflation rate. C) participation rate. D) settlement options.

B) 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.

If a client wishes to purchase a life insurance policy that doesn't invest in the market, but allows the holder to pay additional premium if desired, the recommendation is A) term life. B) universal life. C) index annuity. D) variable life.

B) universal life. Universal life (not universal variable life) does not invest in the market through a separate account. That is only true of life insurance policies using the word "variable." These policies are frequently overfunded (premium over the required amount is paid-in by the policyowner). Term life cannot be overfunded and annuities of any type are not life insurance policies.

In a scheduled premium variable life insurance policy, which of the following are guaranteed? A) A minimum cash value B) 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 C) A minimum death benefit D) 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 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.

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) 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. D) 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. 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.

One way in which universal life and variable life are similar is that both A) have flexible premiums B) have a fixed minimum cash value C) permit loans against the cash value D) are considered securities

C) 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.

A life insurance policy where the premium increases each time the policy is renewed while the face amount remains level is A) increasing term B) decreasing term C) renewable level term D) variable universal

C) renewable level term Level term insurance offers a fixed face amount over the life of the policy. If the policy is renewable, the owner has the ability to renew it for that same face amount and the new term, but at new, higher premiums as the insured's age increases.

A client purchases a fixed annuity that will immediately begin paying $2,000 a month for life. What is the annuitant's greatest risk? A) Market risk B) Capital risk C) Interest rate risk D) Inflation risk

D) Inflation risk Also known as purchasing power risk, inflation risk is the effect of continually rising prices on investments. A client who annuitizes a fixed annuity, receiving $2,000 per month, will likely find the monthly check has less purchasing power as time goes on.

Which of the following statements regarding nonqualified annuities is correct? A) The exclusion ratio applies to accumulation units only. B) Because taxes on earnings are deferred, all money withdrawn will be subject to income tax when received. C) It is possible to receive distributions from an annuity before age 59½ without incurring tax penalties. D) Because only insurance companies issue variable annuities, they are not considered securities.

C) It is possible to receive distributions from an annuity before age 59½ without incurring tax penalties. Nonqualified annuities, fixed or variable, are those where contributions are made with after-tax dollars. Withdrawals due to death or disability or taking substantially equal annuity distributions over the life of the insured can begin before age 59½ without being subject to a tax penalty. The exclusion ratio only applies during the payout period. Even though taxes on earnings are deferred, that portion of the withdrawal that represents a return of principal on a nonqualified annuity, is not subject to tax or penalty.

Which of the following insurance company products is likely to have the longest time for which a surrender charge will be levied? A) Whole life insurance B) Class B shares C) Variable annuity D) Bonus annuity

D) Bonus annuity One of the characteristics of bonus annuities is that their surrender charges tend to be higher for a longer time than other insurance company products. When you see Class B shares on the exam, it will be referring to mutual funds, not insurance company products.

When a variable annuity is annuitized A) the number of annuity units redeemed each payment period varies based upon the performance of the separate account B) the number of accumulation units redeemed each payment period varies based upon the performance of the separate account C) the number of accumulation units redeemed each payment period remains constant D) the number of annuity units redeemed each payment period remains constant

D) 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.

If an index annuity has a participation rate of 80%, it means A) the investor's account will be charged with 80% of the amount lost by the index. B) the investor's account will be credited with 80% of the growth of the index. C) the investor's account will never be less than 80% of the initial investment. D) the investor's account will participate in 80% of the gains and losses of the index.

B) the investor's account will be credited with 80% of the growth of the index. The participation rate of an index annuity is the percentage of the growth of the index credited to the investor's account. For example, if the index had a return of 10% and the participation rate is 80%, the investor's account is credited with 8% growth. This may be limited by a cap (a maximum), but unless a cap rate is stated in the question, there isn't one. One of the benefits of an index annuity is that it only shares in the growth, never any losses.

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) $9,000 is taxable; $6,000 is nontaxable. B) $6,500 is nontaxable; $8,500 is taxable. C) The entire amount is nontaxable. D) The entire amount is taxable.

A) $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.

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) $128,620 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 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.

Which of the following statements is true concerning variable life separate account valuation? A) Unit values are computed monthly and cash values are computed weekly. B) Unit values are computed weekly and cash values are computed monthly. C) Unit values are computed monthly and cash values are computed daily. D) Unit values are computed daily and cash values are computed monthly.

D) Unit values are computed daily and cash values are computed monthly. Unit values are computed each day. Policy cash values are a monthly computation. The death benefit is computed annually.

A 64-year-old woman wishes to withdraw funds from her nonqualified single premium deferred variable annuity purchased a number of years ago. The withdrawal would be A) taxed as ordinary income. B) taxed as capital gain. C) subject to a 10% penalty unless annuitized. D) subject to the required minimum distribution rules.

A) taxed as ordinary income. Yes, we know that only the portion of the withdrawal that exceeds the cost basis is subject to tax, but what else are you going to pick here? We are showing you this question because one similar to it could be on your exam. Sometimes you have to go with the best choice, even if it isn't the most accurate.

Life insurance is generally purchased to replace the lost income of the insured. A client wishing to purchase a policy with a level death benefit and level premium for as long as the premiums are paid would choose A) a decreasing term policy. B) a whole life policy. C) a universal life policy. D) a 5-year renewable term policy.

B) a whole life policy. Whole life insurance is permanent insurance with a level premium and a level death benefit. The renewable term policy may have a level death benefit, but every 5 years, the premium will increase. Universal life has flexible premiums and, depending on the option chosen, the death benefit can increase. Decreasing term insurance, which is often called mortgage life insurance, reduces the death benefit over the life of the policy, as the name implies.

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.

D) may have 20 or more subaccount investment options. 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.

An investor purchased a single payment, deferred non-qualified variable annuity. Each of the following statements is true except A) upon withdrawal, the amount exceeding the investor's cost basis is taxed as ordinary income B) money invested in this annuity represents the investor's cost basis C) random withdrawals are handled under LIFO tax rules D) taxes on earned dividends, interest, and capital gains are paid annually, until the owner withdraws money from the contract

D) taxes on earned dividends, interest, and capital gains are paid annually, until the owner withdraws money from the contract Taxes on earned dividends, interest, and capital gains are not paid annually. They are deferred and paid later, when the owner withdraws money from the contract. Money randomly withdrawn (not annuitized) is handled under LIFO tax rules; money invested in a non-qualified annuity represents the investor's cost basis; and on withdrawal, the amount exceeding the investor's cost basis is taxed as ordinary income.

Surrender charges may cause a reduction to all of the following except A) the redemption value of Class B mutual fund shares B) the cash value of a variable life insurance policy C) the liquidation value of a variable annuity D) the death benefit of a variable life insurance policy

D) the death benefit of a variable life insurance policy Surrender charges never apply in the case of a death benefit. There may be a surrender charge in the case of early surrender of a variable annuity, taking out the cash value of a variable life policy, or redemption of Class B (back-end load) mutual fund shares.

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 as long as he lives, but should he die prior to reaching age 80, Linda will receive payments until Larry's 80th birthday. B) Payments would be made to Larry until he is 80, then to Linda for the remainder of her life. 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 cease.

A) 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.

Juliette, a math teacher in the local high school, owns a qualified, tax-deferred annuity. When she retires, what will be the tax consequences of her annuity payments? A) Her annuity payments are partly taxable as capital gain and partly taxable as ordinary income. B) Her annuity payments are all taxable as ordinary income. C) Her annuity payments are partly taxable and partly tax-free return of capital. D) Her annuity payments are tax free.

B) Her annuity payments are all taxable as ordinary income. The key word here is qualified! The investment Juliette made was with pre-tax dollars, the money grows tax-deferred, and everything is taxed at distribution at ordinary income rates. No annuity payment is ever treated as a distribution of capital gains. Note: On the exam, all contributions to retirement plans are fully -deductible unless something in the question specifies otherwise.

An individual purchasing a flexible premium variable life contract should know which of the following? Timing and amount of premiums generally are discretionary. The death benefit will generally be higher than that of a comparable whole life policy. The face amount is fixed at the beginning of the contract. The performance of the separate account directly affects the policy's cash value. A) I and IV B) II and IV C) I and III D) II and III

A) 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.

Which of the following is guaranteed by a variable life policy? A) Cash value B) Policy loans after the policy has been in effect for at least 24 months C) Minimum separate account performance D) Minimum death benefit

D) Minimum death benefit A variable life policy has a minimum guaranteed death benefit, but there is no minimum guaranteed cash value. There is no performance guarantee on separate accounts, and policy loans are required after the policy has been in effect for at least 3 years (36 months).

All of the following are advantages of universal life insurance except A) the policy is guaranteed never to lapse. B) when the cash value is sufficient, no premium payment is required. C) ability to change death benefit amount. D) ability to adjust the amount of premium payments.

A) the policy is guaranteed never to lapse. A universal life policy may lapse if the accumulation fund drops below a specified level and an additional premium is not paid.

An investor purchases a single premium deferred index annuity with an initial premium of $200,000. Soon after the purchase, the investor receives a statement from the insurance company showing an initial balance of $210,000. The most likely reason for the $10,000 increase is A) this is a bonus annuity. B) the underlying index has had outstanding performance. C) the insurance company paid a dividend. D) the insurance agent's commission was added to the account.

A) this is a bonus annuity. It is not uncommon to find index annuities offering a bonus added to the premium. In this case, the bonus appears to be 5%. There are no dividends on index annuities and rebating commissions is prohibited.

Which of the following statements are true of a variable annuity? The number of annuity units is fixed when payout begins. The value of accumulation units is fixed at purchase. The monthly annuity payment is a variable amount. The annuity payments are not subject to income taxes. A) II and III B) I and III C) III and IV D) I and II

B) I and III The number of annuity units is fixed when an annuitant starts the payout process, and the monthly payment will vary with the market value of the securities in the separate account portfolio. The value of accumulation units varies with the value of the portfolio, and the growth portion of the monthly payments is subject to income tax.

When a client purchased an annuity with a 5% bonus, it means A) the bonus is added at the last payment. B) the bonus is included every payment period. C) the bonus is added to the initial payment. D) the bonus is added to the death benefit.

C) the bonus is added to the initial payment. A bonus annuity is one in which the specified bonus is added to the initial payment. For example, a client invests $100,000 into a 5% bonus annuity. The initial account balance will show as $105,000. In general, all earnings are based on the $105,000 amount. Bonus annuities tend to have longer surrender periods to compensate.

Alexander Wimpton purchased a variable life insurance policy 10 years ago. The policy has a $500,000 face amount which has grown to $525,000 due to the performance of the selected separate account subaccounts. Three years ago, Wimpton borrowed $50,000 against the policy which has never been repaid. The effect of this is that Wimpton's total death benefit today is A) $525,000. B) $500,000. C) $450,000. D) $475,000.

D) $475,000. The death benefit of a variable life insurance policy is the current face amount ($525,000) or the guaranteed minimum, whichever is greater, less any outstanding loans ($50,000).

In a scheduled premium variable life insurance policy, all of the following are guaranteed except A) the right to exchange the policy for a permanent form of insurance, regardless of health, within the first 24 months B) a minimum cash value C) a minimum death benefit D) the ability to borrow at least 75% of the cash value after the policy has been in force at least 3 years

B) a minimum cash value 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 and the 75% cash value loan minimum applies after the 3rd year of coverage.

Annuity companies offer a variety of purchase options to owners. Which of the following definitions regarding these annuity options is not true? A) An accumulation annuity allows the investor to accumulate funds in a separate account prior to investment in an annuity. B) A single premium deferred annuity is a lump sum investment, with payment of benefits deferred until the annuitant elects to receive them. C) An immediate annuity allows an investor to deposit a lump sum with the insurance company; payout of the annuitant's benefits starts immediately (usually within 60 days). D) A periodic payment deferred annuity allows a person to make periodic payments over time; the contract holder can invest money on a monthly, quarterly, or annual basis.

A) An accumulation annuity allows the investor to accumulate funds in a separate account prior to investment in an annuity. Accumulation does not refer to a purchase option. The pay-in period for an annuity is known as the accumulation stage. A single premium deferred annuity is an annuity with a lump-sum investment, with payment of benefits deferred until the annuitant elects to receive them. Periodic payment deferred annuities allow a person to make periodic payments over time. Immediate annuities allow an investor to deposit a lump sum, with the insurance company payout of the annuitant's benefits starting immediately (usually within 60 days).

A variable annuity annuitant bears all of the following risks except A) mortality risk B) inflation risk C) market risk D) interest rate risk

A) 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.

The main benefit that scheduled premium variable life insurance has over whole life insurance is A) the potential for a higher cash value and death benefit. B) a lower sales charge. C) the availability of policy loans. D) an adjustable premium.

A) 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.

Alix purchased a single premium deferred fixed annuity over 10 years ago. She would be subject to taxation on the deferred earnings in which of these cases? A) When she dies B) When the earnings are withdrawn C) If she enters into a Section 1035 exchange D) When the earnings are credited to her account

B) When the earnings are withdrawn Earnings from any deferred annuity are taxed when withdrawn using the LIFO (last-in, first-out) method. A major advantage of a deferred annuity is that all earnings during the deferral period are tax deferred. A special feature available to certain insurance company products, including annuities, is the ability to exchange one annuity for another on a tax-free basis under the provisions of Section 1035 of the Internal Revenue Code. When the annuitant dies, neither she nor her estate are subject to income tax; any tax due is levied against the beneficiary.

In general, when describing the characteristics of equity index annuities and variable annuities, each of the following would be a true statement except A) only the EIA has a minimum guaranteed return B) both offer an opportunity for unlimited gain C) both are issued by life insurance companies D) only the variable annuity is considered a security

B) both offer an opportunity for unlimited gain EIAs almost always come with a cap rate, a ceiling beyond which earnings cannot be credited to the investor's account. There is, theoretically, no limit as to how much one could earn with a variable annuity. Both are issued by life insurance companies, and only the EIA offers a guaranteed floor (minimum return). Based on court rulings in effect at this time, the equity index annuity is not considered a security.

An individual is deciding between a flexible premium variable life contract and a scheduled premium variable life contract. If she is concerned about maintaining a minimum death benefit for estate liquidity needs, she should choose A) the flexible premium policy because earnings of the contract directly affect the face value of the policy and earnings can never be negative B) the scheduled premium policy because the contract is issued with a minimum guaranteed face amount C) the flexible premium policy because the contract's face amount cannot be less than a predetermined percentage of cash value D) the scheduled premium policy because earnings do not affect the contract's face amount

B) the scheduled premium policy because the contract is issued with a minimum guaranteed face amount A scheduled premium variable life contract is issued with a guaranteed minimum death benefit. If the individual is concerned about having the minimum guarantee, you should recommend the scheduled contract.

A married couple, both age 28, are considering the purchase of an annuity to help them save monthly for their retirement at age 65. They want an annuity that will allow them to participate in the equities market, and because of their long-term investment horizon, they are not particularly concerned about safety of principal. Which of the following annuity products best meets their needs? A) Periodic payment deferred fixed annuity B) Single premium deferred fixed annuity C) Periodic payment deferred variable annuity D) Single premium deferred variable annuity

C) Periodic payment deferred variable annuity A variable annuity will allow the couple to participate in the equities market. Fixed annuities are more suited for investors who are concerned with safety of principal. Because the couple plans to save monthly, a single premium deferred annuity, fixed or variable, does not meet their requirements.

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) Not enough information to tell B) The tax consequences would be the same C) The variable annuity D) The mutual fund

C) 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.

In the past 20 years, 55-year-old James has put $27,000 into accumulation units in his nonqualified variable annuity. The current value of his units is $36,000. He wishes to withdraw $16,000 to assist with his grandchild's college education. If he is in the 28% tax bracket, what is his tax consequence on the withdrawal? A) $2,520 B) $0 C) $4,480 D) $3,420

D) $3,420 Because this is nonqualified, the investments are in after-tax dollars. Therefore, any value of the account over the investment is growth. Withdrawals from tax-deferred plans treat the growth as ordinary income for tax purposes. The portion attributable to growth is considered to be withdrawn first under the Tax Code. Here, we have $9,000 worth of growth taxable at 38% (28% + 10% penalty) because James is younger than 59½. Yes, the earnings on a non-qualified annuity are subject to the 10% penalty; it is only the principal that escapes the tax and penalty. The remaining $7,000 withdrawn is considered a withdrawal of principal and is therefore nontaxable.

Which of these features are common to both variable annuities and scheduled premium variable life insurance? Income earned in the separate account is tax deferred. Separate account performance below the AIR causes a reduction in cash value. Fixed contributions are required. Contract owners have voting rights. A) I and IV B) II and III C) III and IV D) I and II

A) I and IV All variable products offer tax deferral of earnings in the separate account. Unit holders of a variable annuity vote on the basis of the number of units they own; holders of variable life insurance receive 1 vote for each $100 of cash value. With variable life insurance, AIR applies only to the death benefit of a variable life policy, not to cash value. Variable annuities earning more or less than the AIR affects the value of the accumulation unit. Scheduled premium variable life has premiums that are fixed, but no such requirement exists with variable annuities.

A 68-year-old individual, who purchased a single premium immediate fixed annuity, elected monthly payments for life with a 10-year certain settlement option. If the individual lives to the age of 80, A) monthly payments will remain fixed until age 78 and then reduce until death. B) monthly payments will cease at age 78. C) monthly payments will continue to the beneficiary(s) for 10 years after the annuitant's death. D) monthly payments will continue until death.

D) monthly payments will continue until death. When choosing the settlement option, life with 10 years certain, the annuitant will receive payments until the later of death or 10 years.

Among the reasons why deferred variable annuities might not be a suitable investment for seniors are all of the following except A) potential capital fluctuation B) improper subaccount selection C) surrender charges D) potential inflation protection

D) 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 client has purchased a nonqualified variable annuity from a commercial insurance company. Before the contract is annuitized, your client, currently age 60, withdraws some funds for personal purposes. What is the taxable consequence of this withdrawal to your client? A) Ordinary income taxation on the earnings withdrawn until reaching the owner's cost basis B) A 10% penalty plus the payment of ordinary income tax on funds withdrawn in excess of the owner's basis C) Capital gains taxation on the earnings withdrawn in excess of the owner's basis D) A 10% penalty plus the payment of ordinary income tax on all of the funds withdrawn

A) Ordinary income taxation on the earnings withdrawn until reaching the owner's cost basis Contributions to a nonqualified annuity are made with the owner's after-tax dollars. Distributions from such an annuity are computed on a LIFO basis with the income taxed first. Once the cost basis is reached, any further withdrawals are a nontaxable return of principal. Because the client is older than 59½ at the time of distribution, the additional 10% penalty tax is not incurred.

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. One product that should be considered to alleviate this concern is A) an annuity. B) whole life insurance. C) an index fund. D) a 30-year term policy.

A) an annuity. 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.

A client of an IAR mentions that he has received a prospectus for a variable annuity, but does not really understand the product. It would be reasonable for the IAR to explain that a variable annuity offers an investor A) a product very similar to a mutual fund, but with lower costs and expenses. B) the insurance company's backing of the annuity' performance . C) the opportunity to invest in equity securities on a tax-deferred basis. D) lifetime income guaranteed never to drop below the initial rate.

C) the opportunity to invest in equity securities on a tax-deferred basis. One of the most attractive features of variable annuities is that all earnings are tax-deferred until withdrawal. The sub-accounts are usually invested in equities (although there are some with fixed income as the primary component of the portfolio), but the expenses are generally higher than for a mutual fund with similar goals. There are no guarantees on the amount of income when the VA is annuitized.

An agent presenting a variable life insurance (VLI) policy proposal to a prospect must disclose which of the following about the insured's rights of exchange of the VLI policy? A) Federal law requires the insurance company to allow the insured to exchange the VLI policy for a permanent form of life insurance policy, issued by the same company for two years with no additional evidence of insurability. B) The insurance company will allow the insured to exchange the VLI policy for a permanent form of life insurance policy within 45 days from the date of the application or 10 days from policy delivery, whichever is longer. C) The insured may request that the insurance company exchange the VLI policy for a permanent form of life insurance policy, issued by the same company, within two years. The insurance company retains the right to have medical examinations for underwriting purposes. D) Within the first 18 months, the insured may exchange the VLI policy for either a permanent form of life insurance or universal variable policy, issued by the same company, with no additional evidence of insurability.

A) Federal law requires the insurance company to allow the insured to exchange the VLI policy for a permanent form of life insurance policy, issued by the same company for two years with no additional evidence of insurability. Federal law requires that issuers of variable life insurance policies allow exchange of these policies for a permanent form of life insurance policy, issued by the same company for a period of no less than two years. The exchange must be made without additional evidence of insurability.

Which of the following statements correctly describes the relationship between annuity units and their value during the payout period of a variable annuity? A) the number of units remains constant, the unit value varies. B) the number of units varies, the unit value varies. C) the number of units remains constant, the unit value remains constant. D) the number of units varies, the unit value remains constant.

A) the number of units remains constant, the unit value varies. Once a variable annuity enters the payout phase, the number of annuity units to be received each month is fixed for life. Since the value of each annuity unit is based on the separate account, the unit value will fluctuate - hence the reason for a variable payout.

A 47-year-old investor purchases a single premium deferred variable annuity from the ABC Insurance Company with an initial premium payment of $25,000. Six years later, a 1035 exchange is made to an annuity offered by the XYZ Insurance Company when the value of the account is $35,000. Seven years later, the account has a current value of $50,000 and the investor withdraws $20,000. The tax consequence of this withdrawal is A) ordinary income tax on $15,000. B) ordinary income tax on $20,000 plus a 10% penalty. C) ordinary income tax on $20,000. D) no tax until the withdrawal exceeds $25,000.

C) ordinary income tax on $20,000. Withdrawals from nonqualified annuities (all annuities on the exam are nonqualified unless otherwise specified) are taxed on a LIFO basis. That is, the last money in (the earnings) is considered the first money withdrawn. The investor's cost is $25,000. The 1035 exchange doesn't affect the cost basis because it is nontaxable. Therefore, with the account currently valued at $50,000, the first $25,000 withdrawn is from the earnings. That makes all of the $20,000 in this question taxable as ordinary income. What about the 10% tax penalty for early withdrawal? If you add the years together (47 + 6 + 7), the investor is 60 and, once reaching 59½, there no longer is the tax penalty.

The value of a variable annuity during the accumulation period is determined by A) the number of accumulation units owned multiplied by the number of payments made into the account B) the value of the securities in the general account of the insurance company C) the number of accumulation units owned multiplied by the value of each unit D) the total payments made by the evaluation date

C) the number of accumulation units owned multiplied by the value of each unit The value of a variable annuity during the pay-in period is based on the value of the accumulation units multiplied by the number of units the investor owns. The value of a unit is based on the value of the securities held in the separate account, not in the general account of the insurance company.

Among the special characteristics of a universal life insurance policy is A) early termination could lead to surrender charges B) that policyowners may borrow against the cash value C) the policy may be overfunded D) death benefits may increase above the initial face amount

C) 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.

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) the potential for a higher cash value and death benefit. D) a lower sales charge.

C) 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.

John owns a nonqualified, tax-deferred annuity. When he retires, what will be the tax consequences of his annuity payments? A) His annuity payments are partly taxable as capital gain and partly taxable as ordinary income. B) His annuity payments are tax free. C) His annuity payments are all taxable as ordinary income. D) His annuity payments are partly taxable and partly tax-free return of capital.

D) His annuity payments are partly taxable and partly tax-free return of capital. The key word here is nonqualified! The investment John made was with after-tax dollars, the money grows tax-deferred, and only the earnings are taxed at distribution. A computation will be made at John's retirement called the exclusion ratio to determine how much of each retirement payment will be treated as a return of cost basis and how much as taxable ordinary income. No annuity payment is ever treated as a distribution of capital gains.

If a customer assumes the risk involved with her variable annuity, what does this mean? She is not assured of the return of her invested principal. The underlying portfolio of the selected subaccount is primarily common stocks, which have no guaranteed return. As an investor, she can be held liable for the debts incurred by the insurance company. A) I, II, and III B) II and III C) III only D) I and II

D) I and II The annuitant bears the investment risk in a variable annuity. This means that the portfolio is not guaranteed to return a specified rate, and the principal invested will also fluctuate in value according to the securities held in the separate account portfolio.