Variable Annuities

Question 1

Variable annuity contracts:

I have the issuer bear the investment risk
II have the purchaser bear the investment risk
III are non-exempt securities
IV are exempt securities

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 1

The best answer is C.

Variable annuities differ from other products sold by insurance companies in that the purchaser bears the investment risk; as opposed to the insurance company bearing the investment risk. For example, if an insurance company achieves poor investment results, this does not affect the amount of death benefit that one gets from a traditional insurance policy; if the separate investment account funding a variable annuity achieves poor investment results, the annuity payment will drop. Because the purchaser bears the investment risk in a variable annuity contract, these are defined by the SEC as a non-exempt security that must be registered and sold with a prospectus.

Question 2

Investment risk in a variable annuity contract is carried by the:

A. purchaser
B. issuer
C. custodian
D. manager

Answer 2

The best answer is A.

Variable annuities differ from other products sold by insurance companies in that the purchaser bears the investment risk; as opposed to the insurance company bearing the investment risk. For example, if an insurance company achieves poor investment results, this does not affect the amount of death benefit that one gets from a traditional insurance policy; if the separate investment account funding a variable annuity achieves poor investment results, the annuity payment will drop. Because the purchaser bears the investment risk in a variable annuity contract, these are defined by the SEC as a non-exempt security that must be registered and sold with a prospectus.

Question 3

Variable annuities are:

A. exempt securities that are sold without a prospectus
B. non-exempt securities that must be sold with a prospectus
C. insurance products that are sold without a prospectus
D. futures products that are sold without a prospectus

Answer 3

The best answer is B.

Variable annuities differ from other products sold by insurance companies in that the purchaser bears the investment risk; as opposed to the insurance company bearing the investment risk. For example, if an insurance company achieves poor investment results, this does not affect the amount of death benefit that one gets from a traditional insurance policy; if the separate investment account funding a variable annuity achieves poor investment results, the annuity payment will drop. Because the purchaser bears the investment risk in a variable annuity contract, these are defined by the SEC as a non-exempt security that must be registered and sold with a prospectus.

Question 4

To sell variable annuities, salespersons must be registered with (the):

I FINRA
II State Insurance Commission
III State Banking Commission

A. I only
B. II only
C. I and II
D. I, II, III

Answer 4

The best answer is C.

To sell a variable annuity, a salesperson must be registered with FINRA with either a Series 6 (mutual funds and variable annuities only) license or Series 7 (general securities) license. In addition, the salesperson must be registered with the State Insurance Commission (since these products are sold by insurance companies; and insurance companies are regulated only at the state level). Banking regulators have nothing to do with securities.

Question 5

The purchaser of a variable annuity bears which of the following risks?

I Interest rate risk
II Expense risk
III Mortality risk
IV Investment risk

A. I and IV only
B. II and III only
C. I, II, III
D. I, II, III, IV

Answer 5

The best answer is A.

Both mortality risk (the risk that the annuitant lives longer than expected) and expense risk (the risk that expenses of running the separate account are higher than expected) are borne by the issuer of a variable annuity contract. The customer assumes the investment risk, since the annuity payment varies with the performance of the securities funding the separate account. With any investment, customers assume legislative risk and interest rate risk. Legislative risk for a variable annuity contract would be Congress changing the tax law. Interest rate risk is inherent in any product that gives the holder a stream of payments - if market interest rates rise, the value of the stream of payments decreases.

Question 6

Variable annuity contracts contain which of the following guarantees?

I Interest Rate Guarantee
II Investment Guarantee
III Mortality Guarantee
IV Expense Guarantee

A. I and II
B. III and IV
C. II, III, IV
D. I, II, III, IV

Answer 6

The best answer is B.

Variable annuity contracts contain a mortality guarantee and an expense guarantee. If one dies later than expected, the company continues to pay the annuity. If expenses rise, the company absorbs them above a set percentage. However, no guarantee is given for the rate of return (investment guarantee or interest rate guarantee) - this is only given for a fixed annuity.

Question 7

Which of the following statements are TRUE about variable annuities?

I Investment risk is carried by the purchaser of the annuity
II Salespeople must register with both FINRA and the State Insurance Commission
III Annuity payments may be reduced because of increased expenses experienced by the insurance company
IV Variable annuities are considered to be securities regulated by the Investment Company Act of 1940

A. I and III
B. II and IV
C. I, II, and IV
D. I, II, III, IV

Answer 7

The best answer is C.

Investment risk in a variable annuity is carried by the purchaser, The issuer gives an expense guarantee, limiting the amount of expenses that the issuer can charge against the contract. To sell variable annuities, both an insurance and a securities registration are required. Variable annuities are considered to be securities because the purchaser bears the investment risk.

Question 8

All of the following are true about variable annuities EXCEPT:

A. salespersons must register with both FINRA and the State Insurance Commission to sell variable annuities
B. annuity payments may not be reduced due to increased expenses experienced by the insurance company
C. variable annuities are considered to be securities regulated by the Investment Company Act of 1940
D. Investment risk is carried by the issuer of the annuity

Answer 8

The best answer is D.

To sell variable annuities, both an insurance and a securities registration are required. The issuer gives an expense guarantee, limiting the amount of expenses that the issuer can charge against the contract. Variable annuities are considered to be securities because the purchaser bears the investment risk. Investment risk in a variable annuity is carried by the purchaser, not the issuer of the contract.

Question 9

Which of the following statements are TRUE about variable annuities?

I Investment risk is carried by the issuer of the annuity
II Salespeople must register with both FINRA and the State Insurance Commission
III Annuity payments may be reduced because of increased expenses experienced by the insurance company
IV Variable annuities are considered to be securities regulated by the Investment Company Act of 1940

A. I and III
B. II and IV
C. II, III, IV
D. I, II, III, IV

Answer 9

The best answer is B.

Investment risk in a variable annuity is carried by the purchaser, not the issuer of the contract. The issuer gives an expense guarantee, limiting the amount of expenses that the issuer can charge against the contract. To sell variable annuities, both an insurance and a securities registration are required. Variable annuities are considered to be securities because the purchaser bears the investment risk.

Question 10

Which of the following statements are TRUE about variable annuities?

I Investment risk is carried by the purchaser of the annuity
II Salespeople must register with both FINRA and the State Insurance Commission
III Variable annuities are considered to be securities regulated by the Investment Company Act of 1940
IV Annuity payments may not be reduced because of increased expenses experienced by the insurance company

A. I and III
C. II, III, IV
D. I, II, III, IV

Answer 10

The best answer is D.

Investment risk in a variable annuity is carried by the purchaser. The issuer gives an expense guarantee, limiting the amount of expenses that the issuer can charge against the contract. To sell variable annuities, both an insurance and a securities registration are required. Variable annuities are considered to be securities because the purchaser bears the investment risk.

Question 11

Typically, accumulation units of variable annuities represent an investment interest in underlying:

A. mutual fund shares
B. life insurance policies
C. direct participation programs
D. pension fund investments

Answer 11

The best answer is A.

To fund variable annuity contracts, the monies paid in by contract holders are invested in a separate investment account that buys designated mutual fund shares. Thus, the separate account “accumulation units” really represent an interest in underlying mutual fund shares. The contract holder has the choice of different types of mutual fund investments that can be made by the separate account.

Question 12

Any changes in value of a variable annuity accumulation unit are directly related to changes in the:

A. Standard and Poor’s 500 Average
B. Value of the securities funding the separate account
C. Consumer Price Index
D. Dow Jones Averages

Answer 12

The best answer is B. Since the separate account of investments funds a variable annuity, accumulation unit values are directly influenced by changes in the values of the securities in the separate account.

Question 13

Which of the following statements are TRUE when describing a variable annuity separate account?

I The separate account is part of the insurance company’s general account holdings
II The separate account is legally segregated from the insurance company’s general account holdings
III The separate account invests in shares of a designated mutual fund
IV The separate account makes direct investments in shares of stock

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 13

The best answer is C.

An accumulation unit is an accounting measure used for valuing a variable annuity holder’s interest in the separate account. The separate account buys shares of a designated mutual fund. The performance of the mutual fund determines the annuity amount to be paid. Direct investments in shares of stock cannot be made in the separate account; the account only buys shares of open-end management companies (mutual funds).

Question 14

Which statements are TRUE regarding variable annuities during the accumulation phase?

I Periodic payments of fixed dollar amounts can be made into the separate account
II Periodic payments of varying dollar amounts can be made into the separate account
III Periodic distributions of fixed dollar amounts can be made to the holder from the separate account
IV Periodic distributions of varying dollar amounts can be made to the holder from the separate account

A. I and II only
B. III and IV only
C. I and III only
D. II and IV only

Answer 14

The best answer is A.

During the accumulation phase of a variable annuity contract, money can be paid into the plan; but distributions cannot be taken. When distributions commence in the annuity phase, no more monies can be paid into the plan. Thus, the accumulation phase allows payments to be made into the plan; but distributions cannot be taken out of the plan.

Question 15

During the accumulation phase of a variable annuity:

A. payments can be made into the plan; but distributions may not be taken from the plan
B. distributions may be taken from the plan; but payments may not be made into the plan
C. both payments may be made into the plan; and distributions may be taken from the plan
D. neither payments may be made into the plan; nor distributions may be taken from the plan

Answer 15

The best answer is A.

During the accumulation phase of a variable annuity contract, money can be paid into the plan; but distributions cannot be taken. When distributions commence in the annuity phase, no more monies can be paid into the plan. Thus, the accumulation phase allows payments to be made into the plan; but distributions cannot be taken out of the plan.

Question 16

During the accumulation phase of a variable annuity contract, reinvested:

I dividends and interest are tax deferred
II capital gains are tax deferred
III dividends and interest are taxable
IV capital gains are taxable

A. I and II only
B. III and IV only
C. I and IV only
D. II and III only

Answer 16

The best answer is A.

During the accumulation phase of a variable annuity contract, all dividends, interest and capital gains earned from the securities in the separate account must be reinvested and build tax deferred. The tax deferral of the build-up is the major benefit of buying a variable annuity.

Question 17

Which statement is TRUE about the taxation of dividends, interest and capital gains in the separate account during the accumulation phase?

A. All dividends, interest and capital gains are taxable in the year received
B. Dividends and interest are taxable in the year received; capital gains are tax deferred
C. Dividends and interest are tax deferred; capital gains are taxable in the year received
D. All dividends, interest and capital gains are tax deferred

Answer 17

The best answer is D.

During the accumulation phase of a variable annuity contract, all dividends, interest and capital gains earned from the securities in the separate account must be reinvested and build tax deferred. The tax deferral of the build-up is the major benefit of buying a variable annuity.

Question 18

An “annuity unit” of a variable annuity contract is a(n):

A. share of common stock representing an interest in the underlying portfolio
B. accounting measure of the owner’s interest in the separate account
C. accounting measure of the annuity amount to be received by the owner
D. share of beneficial interest in a fixed portfolio

Answer 18

The best answer is C.

Once a variable annuity contract is annuitized, accumulation units are converted to annuity units. These determine the annuity payments to be made.

Question 19

Any changes in value of a variable annuity unit are directly related to changes in the:

A. Standard and Poor’s 500 Average
B. Value of the securities funding the separate account
C. Consumer Price Index
D. Dow Jones Averages

Answer 19

The best answer is B.

Since the separate account of investments funds a variable annuity, annuity unit values are directly influenced by changes in the values of the securities in the separate account.

Question 20

Which of the following annuity payment options will continue payments for a specified time period if the annuitant dies prematurely?

A. Life Annuity
B. Life Annuity with Period Certain
C. Joint and Last Survivor Annuity
D. Unit Refund Annuity

Answer 20

The best answer is B.

A life annuity-period certain pays for the annuitant’s life, but if that person dies prematurely, the annuity will pay a designated beneficiary for a specified minimum time period (usually 10 years).

Question 21

Which of the following statements are TRUE about a Life Annuity?

I A Life Annuity will cease when the person dies
II A Life Annuity will continue to pay to a beneficiary if the person dies before a stated date
III The periodic payment for a Life Annuity will be lower than the periodic payment for a Period Certain annuity
IV The periodic payment for a Life Annuity will be higher than the periodic payment for a Period Certain annuity

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 21

The best answer is B.

A life annuity ceases when that person dies. A life annuity-period certain continues to a beneficiary if the person dies prior to the end of the “certain period.” For example, if a life annuity-10 year period certain is purchased, and the purchaser dies after the 3rd year, the annuity continues to pay to a beneficiary for another 7 years. Because of the minimum guaranteed payment period, the periodic payment amount is lower than a simple life annuity (since the insurance company must pay for a longer guaranteed time period).

Question 22

Which of the following statements are TRUE regarding a life annuity?

I The shorter the expected annuity period, the larger the monthly payment
II The longer the expected annuity period, the larger the monthly payment
III A life annuity usually pays the largest amount of all of the annuity payment options
IV A life annuity usually pays the smallest amount of all of the annuity payment options

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 22

The best answer is A.

The shorter the time period to “expected death” when the separate account is annuitized, the larger the monthly payment will be; conversely the longer the time period to “expected death” when the separate account is annuitized, the smaller the monthly payment will be. Regarding annuity payment options, this must be looked at from the standpoint of the insurance company, that has a large pool of annuitants to cover. The insurance company can afford to pay a larger payment to those persons who it expects will be paid for the shortest time period; it will make smaller monthly payments when it expects to pay for a longer time period. A life annuity lasts only for that person’s life - this is the shortest expected period of the annuity payment options. A life annuity with period certain continues to pay for a fixed time period if the person dies early; a joint and last survivor annuity pays a spouse when one person dies; a unit refund annuity pays a lump sum if a person dies early.

Question 23

A 50-year old man has purchased a variable annuity contract. He wants payments for his life, but wants to make sure that payments are made for at least 20 years, should he die prematurely. He should choose a:

A. joint and last survivor annuity option
B. systematic withdrawal plan that provides for 20 years of payments
C. life annuity with a 20 year period certain
D. unit refund annuity

Answer 23

The best answer is C.

A life annuity with a 20 year period certain will pay for the life of the annuitant, but if the annuitant dies early, it will pay for a minimum of 20 years regardless. These payments will be made to a designated beneficiary.

Question 24

A customer, age 60, is looking for an investment that will provide life-long income at retirement. The BEST recommendation would be for the customer to:

A. purchase a variable annuity and annuitize the separate account at retirement
B. purchase a variable annuity and take installments of a designated amount at retirement
C. invest in an income mutual fund and elect not to automatically reinvest distributions
D. invest in a GNMA fund since GNMAs make monthly payments

Answer 24

The best answer is A.

The benefit of an annuity contract to an older person is the assurance of receiving income for life - however this only happens if the customer annuitizes the contract. If the customer chooses installments, there is no guarantee of payments for life - when the money in the account is depleted, payments stop.

Question 25

In a variable annuity contract, the number of

I accumulation units is fixed
II accumulation units can vary
III annuity units is fixed
IV annuity units can vary

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 25

The best answer is C.

During the accumulation phase of a variable annuity contract, new money that is invested buys additional accumulation units of the separate account (analogous to buying shares of a mutual fund). Once the account is annuitized, payments into the separate account must stop. The accumulation units owned at that moment are converted into a fixed number of annuity units (the number of annuity units received is based on that person’s expected mortality). The monthly annuity payment is the fixed number of annuity units times the unit value (which will vary with the performance of the underlying mutual fund held in the separate account).

Question 26

All of the following statements are true for both mutual funds and variable annuities that are in the accumulation phase EXCEPT:

A. both are regulated by the Investment Company Act of 1940
B. both have portfolios that are managed
C. dividend and capital gains distributions are taxable each year for both
D. asset appreciation is untaxed for both

Answer 26

The best answer is C.

Dividend and capital gain distributions made by variable annuity separate accounts must be reinvested and are tax deferred. Dividend and capital gain distributions from other investment companies do not have to be reinvested and are always taxable, whether reinvested or not. Both variable annuities and mutual funds are regulated under the Investment Company Act of 1940; have managed portfolios; and asset appreciation is untaxed. Mutual fund asset appreciation is taxable only when a capital gains distribution is made.

Question 27

Which recommendation would be most suitable for a 40-year old client whose main objective is retirement income and preservation of capital?

A. Fixed deferred annuity
B. Fixed immediate annuity
C. Variable deferred annuity
D. Variable immediate annuity

Answer 27

The best answer is A.

Because this customer is looking for income in retirement and he or she is only 40 years old, a deferred annuity is the right choice. Because the customer wants preservation of capital, a fixed annuity ensures a fixed guaranteed growth rate, while the growth rate of a variable annuity can go higher, or lower, or negative. So for preservation of capital, a fixed annuity is best.

Note that at retirement age, the holder of an annuity can opt for a lump sum payment instead of taking annuity payments, and a fixed annuity guarantees a fixed amount of capital at retirement age, whereas a variable annuity does not.

Question 28

When comparing fixed annuities to variable annuities, which statements are TRUE?

I A fixed annuity account grows at a guaranteed rate
II A variable annuity account grows at a guaranteed rate
III Fixed annuities are subject to investment risk
IV Variable annuities are subject to investment risk

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 28

The best answer is B.

Fixed annuity premiums are invested in an insurance company’s general account and grow at a guaranteed rate (which is usually fairly low). There is no investment risk. At retirement, the customer receives a fixed periodic payment for life.

Variable annuity premiums are invested in an insurance company “separate account” which buys shares of a designated mutual fund. The account grows based on the performance of the underlying mutual fund, so the investor is subject to investment risk.

Question 29

Growth in the separate account of a variable annuity offering a GMIB is:

I guaranteed as to minimum rate
II not guaranteed as to minimum rate
III capped as to maximum rate
IV not capped as to maximum rate

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 29

The best answer is B.

GMIB - Guaranteed Minimum Income Benefit will give a minimum guaranteed growth rate for an additional cost. This guarantee only occurs at annuitization and covers the accumulation phase. The maximum rate that can be earned in the separate account during the accumulation phase is not capped by the GMIB rider.

Question 30

A variable annuity contract offers a GMIB. This is a(n):

I standard feature of variable annuity contracts
II optional feature of variable annuity contracts
III floor on the minimum rate that the separate account will earn
IV cap on the maximum rate that the separate account will earn

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 30

The best answer is C.

A “GMIB” is a Guaranteed Minimum Income Benefit. It is an optional rider offered by many variable annuity contracts. It guarantees that when the separate account is annuitized, if the account has not grown at the guaranteed minimum rate, then the account will be annuitized as if it grew at that guaranteed minimum rate. So if the separate account grows by only 2% a year; and the GMIB is 5%; then the account will be valued at annuitization based on compounding at the 5% minimum benefit. This is a very popular rider, but it does come at a cost.

Question 31

A variable annuity prospectus includes an AIR illustration using a 5% rate. This means that the:

A. purchaser is guaranteed a minimum 5% annual return
B. annuity payment is guaranteed to grow at a minimum of 5% per year
C. return could be less than 5%
D. sales charge will be no higher than 5%

Answer 31

The best answer is C.

The AIR in a variable annuity prospectus is the “Assumed Interest Rate.” It is a conservative illustration of how much the contract holder will receive in payments if the separate account grows at the AIR. If the account grows faster than the AIR, the payments increase. If the account grows slower than the AIR, the payments will decrease.

Question 32

If the actual interest rate earned in the separate account underlying a variable annuity contract is lower than the “AIR,” the annuity payment:

A. will increase
B. will decrease
C. is unaffected
D. is fixed at a minimum amount

Answer 32

The best answer is B.

The “AIR” is the “Assumed Interest Rate.” This is used as an illustration of the annuity payment that will be received if the separate account grows at the AIR. If the assets grow at an interest rate that is higher than the AIR, then the annuity payment will increase. Conversely, if the assets grow at an interest rate that is lower than the AIR, then the annuity payment will decrease.

Question 33

If the actual interest rate earned in the separate account underlying a variable annuity contract is higher than the “AIR” the annuity payment:

A. will increase
B. will decrease
C. is unaffected
D. is capped to a maximum amount

Answer 33

The best answer is A.

The “AIR” is the “Assumed Interest Rate.” This is used as an illustration of the annuity payment that will be received if the separate account grows at the AIR. If the assets grow at an interest rate that is higher than the AIR, then the annuity payment will increase. Conversely, if the assets grow at an interest rate that is lower than the AIR, then the annuity payment will decrease.

Question 34

The “death benefit” associated with a variable annuity contract:

I applies during the accumulation phase
II applies during the annuity phase
III prior to annuitization, the insurance company will pay to a beneficiary, at least the amount invested in the contract
IV after annuitization, the insurance company will pay for the insured’s burial expenses

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 34

The best answer is A.

The “death benefit” of a variable annuity contract is not really much of one. If the contract holder dies prior to annuitization, the insurance company pays the greater of current NAV or the amount invested to a beneficiary. If the contract holder dies after annuitization, there is no more “death benefit.”

Question 35

The “death benefit” associated with a variable annuity contract:

I applies prior to annuitization
II applies after annuitization
III means that, upon death, the insurance company will make a lump sum payment to complete the terms of the contract
IV means that, upon death, the insurance company will pay a beneficiary at least the amount invested in the contract

A. I and III
B. I and IV
C. II and III
D. II and IV

Answer 35

The best answer is B.

The “death benefit” of a variable annuity contract is not really much of one. If the contract holder dies prior to annuitization, the insurance company pays the greater of current NAV or the amount invested to a beneficiary. If the contract holder dies after annuitization, there is no more “death benefit.”

Question 36

A customer has invested $20,000 in a variable annuity. In the first year, the NAV increases to $21,100. At what rate will the $1,100 gain be taxed?

A. 0
B. 15%
C. 20%
D. 25%

Answer 36

The best answer is A.

There is no tax deduction for contributions made to a variable annuity contract. The major advantage is the tax-deferred build-up of earnings in the separate account. When distributions are taken, they are taxable at ordinary income tax rates.

Question 37

A registered representative has a customer, age 50, in the 35% tax bracket, who just sold his house for a 1-time gain. The customer intends to downsize, and after buying a smaller home, will have $400,000 to invest. The customer intends to retire in 15 years. The registered representative could recommend that the customer purchase a variable annuity separate account with a growth objective because:

A. once the customer reaches retirement age, there is no tax due on distributions taken
B. a variable annuity investment held long term will always outperform a fixed annuity contract
C. the contribution will be tax deductible, giving the customer a substantial 1-time tax savings
D. the earnings build tax-deferred during the 15 year period until retirement

Answer 37

The best answer is D.

There is no tax deduction for contributions made to a variable annuity contract. The major advantage is the tax-deferred build-up of earnings in the separate account. Since the return will vary based on the performance of the underlying growth mutual fund, it is not true that it will always be higher than the return from a fixed annuity. When distributions are taken at retirement age, they are taxable as ordinary income, so it is not true that there is no tax due when distributions are taken.

Question 38

A mother, aged 60, wishes to withdraw monies from her variable annuity to pay for her son’s college education. Which statement is TRUE regarding the taxation of the withdrawal?

A. The withdrawal is 100% taxable and is also subject to a 10% penalty tax
B. The withdrawal is 100% taxable
C. The withdrawal is partially taxable; and a partial tax free return of invested capital
D. The withdrawal is not subject to tax

Answer 38

The best answer is C.

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

Question 39

A customer contributed $20,000 to a variable annuity contract. The account value has grown over the years and the NAV is now $35,000. The customer is now age 60, and takes a lump-sum distribution of $20,000 to pay for expenses. Which statement is TRUE?

A. The entire $20,000 distribution is not taxable
B. $5,000 of the distribution is taxable and $15,000 is not taxable
C. $15,000 of the distribution is taxable and $5,000 is not taxable
D. The entire $20,000 distribution is taxable

Answer 39

The best answer is C.

Variable annuity contributions are not tax-deductible. Earnings in the account build tax-deferred. When distributions are taken, tax is due on the portion that represents the tax-deferred build-up. The portion that represents the original contribution (already taxed dollars) is returned without any further tax due. If a lump-sum distribution is taken, the IRS uses LIFO (Last-In; First-Out) accounting. The Last-In Dollars are the tax-deferred build-up, so these are the First-Out dollars and they are 100% taxable! Any distribution above and beyond the build-up amount is a tax-free return of original capital.

In this example, the customer contributed $20,000 and this has grown, tax-deferred, to $35,000. If a lump sum distribution of $20,000 is taken, the first dollars out are the $15,000 of never taxed build-up and this amount is taxable. The remaining $5,000 is a partial tax-free return of the original $20,000 investment (which was not tax deductible).

Question 40

When a non-qualified variable annuity is annuitized prior to age 59 1/2 under the provisions of IRS Rule 72t, the initial payment is:

A. 100% taxable as ordinary income and the 10% penalty tax will be applied
B. 100% taxable as ordinary income but the 10% penalty tax is not applied
C. partially taxable as ordinary income with the 10% penalty tax applied and partially a non-taxable return of investment
D. partially taxable as ordinary income without the 10% penalty tax applied and partially a non-taxable return of investment

Answer 40

The best answer is D.

Instead of taking a lump sum distribution, the owner of a variable annuity contract can “annuitize” and receive annuity payments for life. Each payment has 2 components - an earnings portion that is taxable and a return of capital portion (cost basis) that is not taxable. The non-taxable portion represents the return of the original investment that was made with “after tax” dollars.

IRS Rule 72t gives a way for payments to be taken from the annuity prior to age 59 1/2 without the 10% penalty tax being applied. Rule 72t basically requires that annual payments deplete the account over that individual’s expected life (the IRS has 3 approved methods for this). The rule also requires that a minimum of 5 annual “Substantially Equal Periodic Payments” (SEPPs) be taken, but that payments must continue until at least age 59 1/2.

Question 41

Which statement is TRUE when a non-qualified variable annuity is annuitized prior to age 59 1/2 under the provisions of IRS Rule 72t?

A. 100% of each payment will be taxable at ordinary income rates
B. 100% of each payment will be non-taxable
C. Each payment received will be partially taxable but the 10% penalty tax will not be applied
D. Each payment received will be partially taxable and the 10% penalty tax will be applied

Answer 41

The best answer is C.

Instead of taking a lump sum distribution, the owner of a variable annuity contract can “annuitize” and receive annuity payments for life. Each payment has 2 components - an earnings portion that is taxable and a return of capital portion (cost basis) that is not taxable. The non-taxable portion represents the return of the original investment that was made with “after tax” dollars.

IRS Rule 72t gives a way for payments to be taken from the annuity prior to age 59 1/2 without the 10% penalty tax being applied. Rule 72t basically requires that annual payments deplete the account over that individual’s expected life (the IRS has 3 approved methods for this). The rule also requires that a minimum of 5 annual “Substantially Equal Periodic Payments” (SEPPs) be taken, but that payments must continue until at least age 59 1/2.

Question 42

A client surrenders a variable annuity contract 5 years after purchase because of poor performance. The customer invested $50,000 and redeemed it when the NAV was $40,000, however the customer only received $37,000 because a $3,000 surrender fee was imposed. The tax consequence is:

A. $13,000 capital loss
B. $13,000 deductible ordinary loss
C. $10,000 capital loss and $3,000 non-deductible loss
D. $10,000 deductible ordinary loss and $3,000 non-deductible loss

Answer 42

The best answer is D.

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

Question 43

Which rollovers are permitted without tax due?

I Exchange of one variable annuity contract for another variable annuity contract
II Exchange of a life insurance contract for a variable annuity contract
III Exchange of a variable annuity contract for a life insurance contract
IV Exchange of a life insurance contract for another life insurance contract

A. I and II only
B. III and IV only
C. I, II, IV
D. I, II, III, IV

Answer 43

The best answer is C.

Section 1035 “tax-free” exchanges permit “like-for-like” exchanges without tax due. Thus, Choices I and IV are tax free. It also permits a life insurance policy to be exchanged for a variable annuity without tax due, making Choice II true. Of course, the IRS is happy about this because the taxable annuity payments will start earlier than the payment of the taxable death benefit.

However, a variable annuity cannot be exchanged tax-free for an insurance policy under this tax rule, making Choice III false. If there is a gain in the separate account, it would be taxed upon exchange for a life insurance policy.

Question 44

Which rollover would result in a tax event?

A. Exchange of one variable annuity contract for another variable annuity contract
B. Exchange of a life insurance contract for a variable annuity contract
C. Exchange of a variable annuity contract for a life insurance contract
D. Exchange of a life insurance contract for another life insurance contract

Answer 44

The best answer is C.

Section 1035 “tax-free” exchanges permit “like-for-like” exchanges without tax due. Thus, Choices A and D are tax free. It also permits a life insurance policy to be exchanged for a variable annuity without tax due, making Choice B tax-free. This is allowed because an individual might no longer need the death benefit and has a policy with built up cash value. This can be converted into a fixed or variable annuity, with payments to continue for life, without tax due upon conversion. Of course, the IRS is happy about this because the taxable annuity payments will start earlier than the payment of the taxable death benefit.

If a variable annuity is exchanged for any insurance policy, this is NOT a like-kind exchange, and tax will be due on any appreciation in the separate account. The stance of the IRS is that the individual is only doing this to delay receipt of payments that are taxable (because the variable annuity payments would have been received earlier than the taxable death benefit.)

Question 45

In order to recommend a variable annuity to a customer, the representative should have a reasonable basis to believe that the customer would benefit from:

I tax-deferred growth of the separate account
II the assurance of receiving income for life
III any living or death benefit provided by the contract

A. I only
B. I and II
C. II and III
D. I, II, III

Answer 45

The best answer is D.

Consider this to be a learning question. To recommend a variable annuity, the representative must have a reasonable basis to believe that the customer would benefit from certain features of these products, such as tax-deferred growth, annuitization, or a death or living benefit.

Question 46

In order to recommend a variable annuity to a customer, the representative must inform the customer, in general terms, about any:

I potential surrender period and surrender charge
II potential tax penalty
III mortality and expense fees
IV charges for and features of enhanced riders

A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV

Answer 46

The best answer is D.

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

Question 47

The owner of a variable annuity has which of the following rights?

I Right to vote for the sales charge imposed on purchases
II Right to vote to change the separate account’s investment objective
III Right to vote for the Board of Trustees
IV Right to vote for the dissolution of the trust

A. I and II only
B. III and IV only
C. II, III, IV
D. I, II, III, IV

Answer 47

The best answer is C.

The sales charge imposed on purchases is decided by the variable annuity’s Board of Trustees. The unit holder can vote for the Board of Trustees and can vote to change the investment objective of the separate account. In addition, terminating the trust (a very unlikely event) would require unit holder approval as well.

Question 48

Which of the following statements is (are) TRUE regarding variable annuity contracts?

I The principal amount is guaranteed prior to annuitization by the insurance company that issues the contract
II The principal amount is guaranteed after annuitization by the insurance company that issues the contract
III The contract holder loses control of the principal amount prior to annuitization
IV The contract holder loses control of the principal amount after annuitization

A. I and III only
B. II and IV only
C. IV only
D. I, II, III, IV

Answer 48

The best answer is C.

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

Question 49

When referring to guarantees in a variable annuity contract, a registered representative would be permitted to say all of the following EXCEPT:

A. “The contract may provide for a guaranteed minimum income benefit for an additional premium”
B. “The contract may provide for a guaranteed minimum death benefit”
C. “The contract may provide for payments over a guaranteed time period”
D. “The contract may provide for a guaranteed return on investment in the separate account”

Answer 49

The best answer is D.

A GMIB (Guaranteed Minimum Income Benefit) is an optional rider that can be purchased in most variable annuity contracts. At retirement age, if the separate account has not grown by the guaranteed minimum rate, the separate account will still be annuitized based on the guaranteed minimum growth rate - so Choice A is a true statement.

Variable annuities offer a “death benefit” during the accumulation phase. If the owner dies before annuitization, the insurance company will return all payments made to a beneficiary - so Choice B is a true statement.

One of the annuity options available is a Life Annuity - Period Certain, which guarantees that if the purchaser dies before a minimum time period (say 15 years), the payments will still be made to a beneficiary for the remainder of time until 15 years is completed - so Choice C is true.

Choice D is false - the investment return in the separate account depends on the performance of the underlying mutual fund - it will vary and is not guaranteed.