What is included when calculating the benefit on a variable annuity contract quizlet?

A
permanent insurance

B
cash value

Correct answer
C
general account

D
level premium

Any "variable" product, either a variable annuity or variable life insurance, takes the premium and invests it in a designated separate account, also called a subaccount, that invests in a specified mutual fund. The performance of the mutual fund builds cash value in a variable life policy. This cash value build can be borrowed from the policy. If the cash value grows to more than the death benefit and has not been borrowed, then the policy will pay the higher cash value on death.
Variable life is "permanent insurance" - as long as the premium is paid, the policy is in effect. This contrasts with term insurance, which has a stated term, after which the policy expires and must be renegotiated. The premium amount is level - the same premium payment is paid periodically. What will vary is the cash value build and the amount of insurance coverage, based on the performance of the separate account.
In contrast, whole life is another form of permanent insurance. It invests premiums in the insurance company's general account, which is typically invested safely, mainly in bonds. The cash value builds at a fixed rate, and the coverage amount does not vary.

C)
$8,750

Explanation
Only the deferred growth is taxable on a LIFO (last-in, first-out) basis. In this case, it is the amount of the withdrawal in excess of the cost of $25,000. Using LIFO, all of the withdrawal is part of the $47,000 in earnings that have been generated. That $25,000 is taxed at the marginal rate of 25%. Furthermore, because the investor is under 59½ (38 + 20 = 58), there is the additional 10% penalty tax. Effectively, this is a 35% tax on $25,000. Remember, all annuities are nonqualified unless stated otherwise in the question.
LO 9.d

Bob Smith, who is in his 40s, has just become covered by an extremely generous defined benefit retirement plan at his company. He has decided he no longer needs his variable annuity for retirement purposes and wants to use the money for a trip to Africa. Over the past 10 years, he has invested $60,000 in the annuity, and its net value is now $80,000. If Bob should go ahead and surrender the annuity, the tax consequences will be
A)
ordinary income tax on $60,000 and a $6,000 penalty.
B)
capital gains tax on $60,000 and a $6,000 penalty.
C)
ordinary income tax on $20,000 and a $2,000 penalty.
D)
capital gains tax on $20,000 and a $2,000 penalty.

C. $2,800

The amount contributed to a non-qualified variable annuity may not be deducted from income; in other words, the contribution is made after-tax. However, all of the earnings will accrue on a tax-deferred basis. Any withdrawal from the annuity will be taxed on a LIFO basis, which means that the earnings (last in) will be considered the first to be withdrawn and will be taxed. If being withdrawn, the earnings are taxed as ordinary income, but the invested amount is considered a return of capital and is not taxed.

In this question, the annuity has earnings of $10,000 (from $30,000 to $40,000), but the investor is withdrawing $20,000. Therefore, the first portion of the withdrawal is the $10,000 of earnings (which is taxable at the investor's ordinary rate) and the remaining $10,000 is considered a return of capital (which is untaxed). This results in tax liability of $2,800 ($10,000 of earnings x 28% tax bracket).

Recommended textbook solutions

Fundamentals of Financial Management, Concise Edition

10th EditionEugene F. Brigham, Joel Houston

777 solutions

Advanced Accounting

11th EditionJoe B. Hoyle, Thomas F. Schaefer, Timothy S. Doupnik

1,062 solutions

Corporate Financial Accounting

12th EditionCarl Warren, James M Reeve, Jonathan E. Duchac

1,486 solutions

Fundamentals of Financial Management

12th EditionEugene F. Brigham, Joel F Houston

189 solutions

Which of the following statements is true about a variable annuity contract quizlet?

Which of the following choices is found in a variable annuity but not in a mutual fund?

Which statements are true about variable annuity contracts?

Which of the following regulates variable annuities?