Variable Products

Variable Annuities: Overview

A variable annuity is an insurance product and securities product combined. It is a contract between an individual and an insurance company that provides tax-deferred growth and the option to receive a stream of income payments (annuitization) at a future date. Because the returns depend on the performance of underlying investment subaccounts, variable annuities are considered securities and require both a securities license (Series 6 or Series 7) and a state insurance license to sell.

Variable annuities are popular retirement planning tools because they offer:

• Tax-deferred growth: Earnings grow without being taxed until withdrawn
• No contribution limits: Unlike IRAs and 401(k)s, there is no annual contribution limit for non-qualified annuities
• Death benefit: A guaranteed minimum death benefit (typically the greater of account value or total premiums paid)
• Lifetime income option: The ability to annuitize and receive income payments for life
• Investment choices: Multiple subaccounts (similar to mutual funds) to choose from

The Two Phases of an Annuity

Every annuity has two distinct phases:

Accumulation Phase

During the accumulation phase (also called the pay-in period), the contract owner makes premium payments that are invested in subaccounts. Key points:

• Accumulation units: Premiums purchase accumulation units in the subaccounts. The value of these units fluctuates daily based on investment performance.
• Separate account: The subaccounts are held in the insurer's separate account, which is segregated from the insurer's general account. The investment risk is borne by the contract owner, not the insurance company.
• Subaccounts: Similar to mutual funds, each subaccount has its own investment objective (growth, income, bond, money market, etc.). The owner can allocate premiums among multiple subaccounts and typically can switch between subaccounts without triggering a taxable event.
• Tax-deferred growth: Earnings are not taxed until withdrawn. This allows compound growth without annual tax drag.

Annuitization Phase

When the owner decides to begin receiving income, the contract enters the annuitization phase (also called the pay-out period). Key points:

• Annuity units: Accumulation units are converted into a fixed number of annuity units. The number of annuity units never changes, but the value of each unit varies based on the separate account's investment performance compared to the Assumed Interest Rate (AIR).
• Assumed Interest Rate (AIR): A benchmark rate used to calculate the initial annuity payment. If the separate account earns MORE than the AIR, the next payment increases. If it earns LESS than the AIR, the next payment decreases. If it earns exactly the AIR, the payment stays the same.
• Irrevocable: Once annuitized, the decision generally cannot be reversed. The owner gives up control of the lump sum.

Fees, Surrender Charges, and Death Benefit

Variable Annuity Fees

Variable annuities typically have multiple layers of fees:

• Mortality and Expense (M&E) Risk Charge: Compensates the insurer for insurance risks (death benefit guarantee, lifetime income guarantee). Typically 1.0% to 1.5% annually. Deducted from the separate account.
• Administrative fees: Cover recordkeeping and other administrative costs. May be a flat annual fee or a percentage of account value.
• Subaccount management fees: Similar to mutual fund expense ratios, charged by the underlying subaccount managers. Typically 0.50% to 1.50% annually.
• Optional rider fees: Additional charges for optional benefits like guaranteed minimum income benefit (GMIB), guaranteed minimum withdrawal benefit (GMWB), or enhanced death benefit. These can add 0.25% to 1.00% annually.

Surrender Charges

Surrender charges are back-end fees assessed if the owner withdraws money or surrenders the contract during the surrender period (typically 6-8 years). The charge usually starts at 7-8% and declines by 1% per year.

• Many contracts allow penalty-free withdrawals of up to 10% of account value per year
• Surrender charges are separate from the IRS 10% early withdrawal penalty
• The surrender period restarts if the contract is exchanged (1035 exchange) to a new annuity

Death Benefit

Most variable annuities guarantee a minimum death benefit. If the contract owner or annuitant dies during the accumulation phase, the beneficiary receives the greater of:

• The current account value, OR
• The total premiums paid (minus any withdrawals)

This protects beneficiaries if the subaccounts have declined in value. Some contracts offer enhanced death benefits (e.g., the highest anniversary value) for an additional fee.

Tax Treatment of Variable Annuities

The tax treatment of variable annuities is one of the most tested topics in this area of the Series 7.

Non-Qualified Annuities (After-Tax Money)

• Contributions: Made with after-tax dollars. Not tax-deductible.
• Growth: Tax-deferred until withdrawn.
• Withdrawals: Taxed on a Last-In, First-Out (LIFO) basis. Earnings come out first and are taxed as ordinary income. Once all earnings are withdrawn, the remaining withdrawals represent the return of principal (cost basis) and are tax-free.
• 10% early withdrawal penalty: Applies to earnings withdrawn before age 59-1/2, in addition to ordinary income tax. Exceptions exist for death, disability, and certain annuitized payments (Section 72(t) substantially equal periodic payments).

Qualified Annuities (Pre-Tax Money)

• Contributions: Made with pre-tax dollars (e.g., within an IRA or employer plan). Tax-deductible.
• Growth: Tax-deferred.
• Withdrawals: 100% taxable as ordinary income (since no taxes have ever been paid on any portion).
• 10% penalty: Same rules apply for withdrawals before age 59-1/2.
• Required Minimum Distributions (RMDs): Must begin at age 73 (under current law).

1035 Exchanges

A Section 1035 exchange allows the owner to transfer the value of one annuity contract to another annuity contract (or one life insurance policy to another) without triggering a taxable event. Key rules:

• Annuity to annuity: Permitted tax-free
• Life insurance to annuity: Permitted tax-free
• Annuity to life insurance: NOT permitted tax-free
• The exchange must be a direct transfer between insurance companies (not an indirect rollover)
• A new surrender charge period typically begins with the new contract
• FINRA scrutinizes 1035 exchanges closely to ensure the exchange benefits the customer, not just the representative (who earns a new commission)

Annuity Payout Options

When the contract owner annuitizes, they must select a payout option. The choice affects the payment amount and how long payments continue. The following are the most common options:

Life Only (Straight Life)

Payments continue for the annuitant's entire lifetime. When the annuitant dies, payments stop immediately with no further obligation to beneficiaries. This option provides the highest periodic payment because the insurer's obligation ends at death.

Life with Period Certain

Payments continue for the annuitant's lifetime, but with a guaranteed minimum period (e.g., 10 years, 20 years). If the annuitant dies before the certain period expires, the beneficiary receives the remaining payments for the rest of the guaranteed period. Payments are lower than life only because of the guarantee.

Joint and Last Survivor (Joint Life)

Payments continue as long as either of two annuitants is alive. When the first annuitant dies, payments continue to the surviving annuitant (often at a reduced amount, such as 50% or 75%). This provides the lowest periodic payment because the insurer's obligation covers two lifetimes.

Fixed Period (Period Certain Only)

Payments are made for a fixed number of years regardless of whether the annuitant lives or dies. If the annuitant dies before the period ends, the beneficiary receives the remaining payments. This is NOT a life contingency option; if the annuitant outlives the period, payments stop.

Variable Life Insurance (VLI)

Variable Life Insurance (VLI) is a permanent life insurance policy that combines a death benefit with an investment component. Like variable annuities, VLI is both an insurance product and a securities product, requiring dual registration to sell.

Key Features

• Fixed premiums: Unlike variable annuities, VLI has scheduled, level premiums that must be paid on time.
• Separate account: A portion of the premium (after insurance costs and expenses) is invested in the insurer's separate account through subaccounts chosen by the policyholder. The investment risk is borne by the policyholder.
• General account: The minimum guaranteed death benefit is supported by the insurer's general account (guaranteed investments like bonds).
• Minimum death benefit: VLI guarantees a minimum death benefit regardless of separate account performance. If investments perform well, the death benefit increases. If they perform poorly, the death benefit cannot fall below the guaranteed minimum.
• Cash value: The policy builds cash value based on separate account performance. There is no guaranteed minimum cash value in a variable life policy. The cash value can decline to zero if investments perform poorly.
• Policy loans: The policyholder can borrow against the cash value. Policy loans reduce the death benefit. Loans are generally not taxable unless the policy is a Modified Endowment Contract (MEC).

Separate Account vs. General Account

• Separate account: Holds the variable (investment) portion of VLI and variable annuities. Assets are segregated from the insurer's other assets. If the insurance company becomes insolvent, separate account assets are protected from creditors. Regulated as a security (SEC registration required).
• General account: Holds the insurer's guaranteed obligations (fixed annuities, guaranteed minimum death benefits, whole life cash values). Invested conservatively in bonds and mortgages. Subject to claims of the insurer's creditors in insolvency. Regulated as an insurance product, NOT a security.

Fixed Annuities vs. Variable Annuities

Understanding the differences between fixed and variable annuities is essential for the Series 7, both for exam questions and suitability recommendations.

529 Plans (Qualified Tuition Programs)

Section 529 plans are tax-advantaged savings plans designed to encourage saving for future education costs. They are sponsored by states or state agencies and can be used at eligible educational institutions nationwide.

Key Features

• Contributions: Made with after-tax dollars. Not deductible on federal returns, but many states offer a state income tax deduction or credit for contributions to their own state's plan.
• Growth: Tax-free (not just tax-deferred) if used for qualified education expenses.
• Qualified expenses: Tuition, fees, books, supplies, room and board (for at least half-time students), computers, and internet access. Also includes up to $10,000 per year for K-12 tuition and student loan repayment (up to $10,000 lifetime per beneficiary).
• Non-qualified withdrawals: Earnings portion is subject to ordinary income tax plus a 10% penalty.
• No income limits: Anyone can contribute regardless of income (unlike Coverdell ESAs).
• High contribution limits: Typically $300,000-$500,000+ per beneficiary (varies by state).
• Control: The account owner (typically a parent or grandparent) retains control of the assets. The beneficiary has no right to the funds.
• Beneficiary changes: The beneficiary can be changed to another qualifying family member without tax consequences.

Gift Tax Treatment and Superfunding

529 plan contributions are considered completed gifts for estate and gift tax purposes. Special rules apply:

• Annual contributions up to the gift tax exclusion amount ($18,000 per beneficiary in 2024, adjusted for inflation) are free of gift tax.
• Superfunding (5-year election): A contributor can make a lump-sum contribution of up to 5 times the annual gift tax exclusion (e.g., $90,000) and elect to spread it over 5 years for gift tax purposes. This allows a large upfront investment to begin compounding immediately. If the contributor dies within the 5-year period, a prorated portion is included in their estate.
• Married couples can each contribute up to 5x the annual exclusion per beneficiary (effectively up to $180,000 jointly with the 5-year election).

Coverdell Education Savings Accounts (ESAs)

Coverdell Education Savings Accounts (formerly Education IRAs) are tax-advantaged accounts used to save for a beneficiary's education expenses from kindergarten through graduate school.

• Maximum annual contribution: $2,000 per beneficiary per year (from all sources combined)
• Income limits: Contributions phase out for single filers with MAGI between $95,000 and $110,000, and for joint filers between $190,000 and $220,000
• Contributions: After-tax (not deductible)
• Growth and withdrawals: Tax-free if used for qualified education expenses (elementary, secondary, or post-secondary)
• Broader qualified expenses: Can be used for K-12 expenses (tutoring, uniforms, transportation) as well as college costs
• Beneficiary age: Contributions can only be made until the beneficiary turns 18. Assets must be distributed by age 30 (or transferred to another family member under 30).
• Self-directed: The account owner chooses specific investments (stocks, bonds, mutual funds, etc.), unlike 529 plans which offer predetermined investment options.