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Difficulty: MediumAnnuities and Insurance-Based Products

An investor purchases a non-qualified variable annuity contract to build assets for long-term retirement planning. Which of the following statements regarding the contract's features, investment risks, and tax characteristics during the accumulation phase are correct?

  1. Investment growth within the subaccounts of the separate account accumulates on a tax-deferred basis.Answer
  2. The contract owner assumes the investment risk related to the performance of the chosen subaccounts.Answer
  3. C
    Payment of insurer surrender charges satisfies and waives the 10% IRS tax penalty on taxable withdrawals made prior to age 59½.
  4. D
    Contributions to the non-qualified annuity reduce the investor's current adjusted gross income, and subsequent earnings withdrawals are taxed at long-term capital gains rates.

Answer

Tax-deferred growth of earnings within subaccounts and investor assumption of subaccount market risk are correct characteristics of non-qualified variable annuities.
Growth within separate account subaccounts is tax-deferred until distribution, and the contract owner assumes full investment risk associated with subaccount market performance. These are core structural features of variable annuities.

Step-by-Step Solution

1
Analyze tax treatment during accumulation phase
Earnings in non-qualified variable annuities grow tax-deferred until withdrawal.
Internal Revenue Code regulations allow investment gains within insurance company separate accounts to compound without triggering immediate tax liability.
2
Evaluate risk allocation between insurer and contract owner
The investor bears subaccount investment risk.
Separate accounts function similarly to mutual funds; unlike fixed annuities backed by the insurer's general account, variable subaccounts offer no guaranteed rate of return.
3
Evaluate surrender charges vs. IRS penalties and taxation rules
Surrender charges do not remove tax penalties, and earnings are taxed as ordinary income.
Surrender charges compensate the insurance company for early contract withdrawal, whereas the 10% IRS penalty is a statutory tax penalty for early distribution. Additionally, annuity gains are taxed as ordinary income.

Key Concept

Tax deferral and market risk features of variable annuity separate accounts
Estimated Time:1m 30s
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Topics

Annuities and Insurance-Based Products

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