Purchasing and Withdrawing From Annuities

Question 1

A qualified, tax-deferred annuity. What will be the tax consequences of annuity payments?

Answer 1

Annuity payments are all taxable as ordinary income

(The key word here is qualified! The investment 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.)

Question 2

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,

Answer 2

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.)

Question 3

Describe the relationship between annuity units and their value during the payout period of a variable annuity?

Answer 3

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.)

Question 4

Taxes on earned dividends, interest, and capital gains of a single payment, deferred non-qualified variable annuity are:

Answer 4

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Money randomly withdrawn (not annuitized) is handled under LIFO tax rules; money invested in a non-qualified annuity represents the investor’s cost basis; and on withdrawal, the amount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.

Question 5

Which of the following statements are true of a variable annuity?

I. The number of annuity units is fixed when payout begins.

II. The value of accumulation units is fixed at purchase.

III. The monthly annuity payment is a variable amount.

IV. The annuity payments are not subject to income taxes.

Answer 5

I & III

I. The number of annuity units is fixed when payout begins.

III. The monthly annuity payment is a variable amount.

(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.)

Question 6

A 45-year-old investor takes a lump-sum distribution from a nonqualified variable annuity. How is the distribution taxed?

I. The entire amount is taxed as ordinary income.

II. The growth portion is taxed as ordinary income.

III. The growth portion is taxed as a capital gain.

IV. The growth portion is subject to a 10% penalty.

Answer 6

II & IV

II. The growth portion is taxed as ordinary income.

IV. The growth portion is subject to a 10% penalty.

(On withdrawals from a nonqualified annuity, taxes are paid only on the amount that exceeds cost basis (the amount paid into the annuity). In this case, the investor is taking a lump-sum distribution before reaching age 59½ and must pay an additional 10% penalty on the taxable amount.)

Question 7

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?

Answer 7

$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.)

Question 8

A client has been contributing to a periodic payment annuity for 20 years. The M&E (mortality & expense) charge is 1.25% per year. What happens to that charge when the client annuitizes at attained age 68?

Answer 8

It ceases.

(The M&E charge is for mortality and expenses. Once an annuity contract, fixed or variable, is annuitized, that charge no longer applies to the account. There may be an internally computed charge, but unlike the accumulation period, the charge is not broken out separately)

Question 9

The value of a variable annuity during the accumulation period is determined by

Answer 9

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.)

Question 10

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:

Answer 10

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.)

Question 11

Nonqualified Annuities

Answer 11

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.)

Question 12

An investor purchases a single premium deferred index annuity with a 6% bonus feature. The premium was $100,000. The annuity has an 80% participation rate with a 10% cap. If the underlying index increased by 15%, the account’s value at the end of the year would be:

Answer 12

$116,600

(The 6% bonus means that the client’s initial payment is increased by 6%. That means the account shows a starting balance of $106,000. Although the index increased by 15% and the participation rate of 80% would be a 12% growth rate, the cap of 10% comes into play. That makes the calculation: $106,000 x 110% or $116,600.)

Question 13

When a variable annuity is annuitized:

Answer 13

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.)

Question 14

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?

Answer 14

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.)

Question 15

Insurance company products is likely to have the longest time for which a surrender charge will be levied?

Answer 15

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.)

Question 16

What Is a Bonus Annuity?

Answer 16

At its core, a bonus annuity is an insurance product designed to incentivize investors by offering an immediate or first-year, bonus to their annuity balance. This bonus mainly falls between 1% and 10% of the initial investment, enabling an immediate boost in the annuity’s value.

To benefit from a bonus annuity, an investor purchases the annuity from an insurance company, which then adds an upfront bonus. Over time, as the annuity accrues interest, the investor receives periodic payouts. It can serve as a steady income source frequently used during retirement. But to contextualize where a bonus annuity fits into the wider financial spectrum, the return can be compared to other investment options like mutual funds, which do not supply an upfront bonus.

Question 17

An accumulation annuity

Answer 17

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).

Question 18

When a customer wants income from an annuity and chooses the option of life with 20-year period certain, how will distributions be taxed?

Answer 18

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.

Question 19

If your 60-year-old customer purchases a nonqualified variable annuity and withdraws some of her funds before the contract is annuitized, what are the consequences of this action?

Answer 19

Ordinary income tax on earnings exceeding basis.

The IRS taxes distributions from a nonqualified annuity using LIFO. That is, the last money in (the earnings) is the first money withdrawn. The income was deferred from tax, so it is taxable as ordinary income once distributed. A 10% penalty applies only if distributions begin before age 59½.

Question 20

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?

Answer 20

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.

Question 21

A client has invested $25,000 into a variable annuity which has grown to $150,000 over the accumulation period. At age 60, the account is liquidated. The tax treatment of the withdrawal would be?

Answer 21

ordinary income tax on $125,000.

Any increase in the value of a variable annuity is taxed as ordinary income, never capital gain. In this case, there is no 10% penalty tax because the client is over 59½ years old. On the exam, all annuities are non-qualified unless the question says it is qualified or there is a clue, such as being part of a 403(b) plan.

Question 22

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?

Answer 22

$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.

Question 23

John owns a nonqualified, tax-deferred annuity. When he retires, what will be the tax consequences of his annuity payments?

Answer 23

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.

Question 24

Features of straight life, fixed, single-premium immediate annuity

Answer 24

1) payments do not increase with inflation.
2) the annuitant may die before a return of the principal is realized.
3) payments stop when the annuitant dies.

Payments from a straight life, fixed, single-premium immediate annuity are fixed and are not dependent on underlying investments. However, as fixed payments, they do not offer inflation protection. As a straight life annuity, payments cease at the death of the annuitant. Because there is no minimum payout period, early death could result in total payments being less than the amount of the invested principal.

Question 25

A customer has invested a total of $10,000 in a nonqualified deferred annuity through a payroll deduction plan offered by the school system where he works. The annuity contract is currently valued at $16,000, and he plans to retire. On what amount will the customer be taxed if he chooses a lump-sum withdrawal?

Answer 25

$6,000

Payments into a nonqualified deferred annuity are made with after-tax money; taxes must only be paid on the earnings of $6,000.

Question 26

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 annuity products best meets their needs?

Answer 26

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.

Question 27

An owner of an annuitized annuity

Answer 27

1) receive the benefits for life with a certain minimum period of time guaranteed.
2) have a joint life with last survivor clause, with payments paid, until the death of the last survivor.
3) receive the benefits on a monthly basis until the time of death.

The contract is annuitized when the investor converts from the accumulation (pay-in) stage to the distribution (payout) stage. Once that happens, the owner no longer has control over the asset. All payout decisions must be selected in advance because they cannot be changed.

Question 28

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 settlement option?

Answer 28

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.