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Difficulty: MediumAnnuities and Insurance-Based Products

An investor is evaluating the purchase of a non-qualified variable annuity contract to supplement retirement savings. Which of the following statements regarding the account structure, investment risks, and taxation of non-qualified variable annuities are correct?

  1. Earnings accumulated within the separate account grow on a tax-deferred basis until distributions begin.Answer
  2. The contract owner bears the investment risk associated with the performance of the underlying subaccounts.Answer
  3. C
    Premature withdrawals taken prior to age 59½ are subject to a 10% IRS tax penalty assessed on the entire withdrawal amount.
  4. D
    Allocating contract values across multiple subaccount asset classes eliminates systematic market risk.

Answer

Tax-deferred accumulation of earnings within the separate account and the transfer of investment risk to the contract holder are correct features of non-qualified variable annuities.
Non-qualified variable annuities feature tax-deferred growth of earnings within the separate account during accumulation. Because performance is tied directly to subaccount market returns rather than guaranteed general account rates, the contract owner assumes all investment risk.

Step-by-Step Solution

1
Analyze tax mechanics during the accumulation phase of a non-qualified variable annuity.
Dividends, interest, and capital gains generated in the separate account compound tax-deferred until withdrawal.
IRS rules defer income taxation on non-qualified annuity growth until distributions are made.
2
Evaluate the risk allocation between the insurer and contract owner.
The investor assumes investment risk because subaccount performance directly determines account value fluctuations.
Separate accounts do not carry guaranteed fixed returns from the insurance company's general account.
3
Examine the early withdrawal penalty rules.
Withdrawals are taxed on a LIFO (last-in, first-out) basis; the 10% IRS penalty applies only to taxable earnings, not principal.
Non-qualified contributions represent post-tax dollars and are returned tax-free.
4
Assess the impact of diversification on market risks.
Systematic risk affects the broader market and cannot be eliminated by asset allocation.
Subaccounts holding equity securities remain subject to overall stock market downturns.

Key Concept

Variable Annuity Risk and Tax Characteristics
Estimated Time:1m 30s
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Topics

Annuities and Insurance-Based Products

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