- Which of the following statements is true regarding variable life insurance?
Answer: The policy's cash value is invested in a separate account, the policyowner bears the investment risk, and the variable life policy is a security under federal securities law.
Under federal securities law, a traditional variable life policy is a security. Its cash value is invested in separate accounts rather than the insurer's general account, and the policyowner bears the investment risk of those accounts. The statement that a guaranteed minimum death benefit eliminates investment risk and makes the policy a non-security is wrong: the cash value element still exposes the policyowner to market risk, and the policy is registered as a security. The statement describing flexible premiums and an adjustable death benefit describes variable universal life, not a traditional variable life policy, which has fixed, level premiums. The statement that the cash value is held in the general account and credited with a guaranteed minimum rate describes a fixed whole life policy; the death benefit of a variable policy is not driven by a general-account rate.
- Which of the following statements is true regarding variable annuity contracts under federal securities law?
Answer: A variable annuity's separate account is typically organized and registered under the Investment Company Act of 1940 as a unit investment trust, and the annuity contracts are registered under the Securities Act of 1933.
A variable annuity is a security. The separate account that funds it is registered under the Investment Company Act of 1940, typically as a unit investment trust, and the variable annuity contracts themselves are registered under the Securities Act of 1933. The statement that the separate account is ordinarily organized as an open-end management investment company is wrong: open-end management companies are the mutual fund form, while variable annuity separate accounts normally use the unit investment trust form; the variable annuity contract is also not categorically exempt from Securities Act registration. The statement that the insurer bears the investment risk and that the contract is subject only to insurance regulation is wrong: the defining feature of a variable annuity is that the contractholder bears the investment risk of the separate account. The statement that antifraud rules do not apply is wrong: the antifraud provisions of the federal securities laws apply to the offer and sale of a security, and classifying a product as an insurance product does not remove that liability.
- For tax year 2026, which of the following statements is true regarding the federal income tax treatment of a life insurance policy that is not a modified endowment contract (MEC)?
Answer: The death benefit paid to a named beneficiary is excluded from the beneficiary's gross income, and withdrawals are treated first as a tax-free recovery of the policyowner's cost basis.
For tax year 2026, Internal Revenue Code § 101(a)(1) excludes life insurance death proceeds from the beneficiary's gross income, and for a policy that is not a MEC, cash-value withdrawals are treated under § 72(e) as a tax-free recovery of the owner's cost basis before any gain is recognized. The LIFO statement is wrong: LIFO applies to distributions from non-qualified annuities and from MECs, not to non-MEC life insurance withdrawals. The statement that surrender is a nontaxable event is wrong: surrender is taxable to the extent the cash surrender value exceeds the owner's cost basis, and the gain is ordinary income. The statement that policy loans are never taxable is wrong: while an outstanding loan is not income while the policy remains in force, a later lapse or surrender with the loan unpaid treats the loan as a distribution, taxable to the extent it exceeds the owner's cost basis.
A 70-year-old client owns a non-qualified variable annuity with a cost basis of $80,000. At the client's death, the contract value is $140,000. The client's adult son, the sole beneficiary, elects a lump-sum distribution.
Which statement correctly describes the tax treatment of the distribution to the son? Answer: The son includes $60,000 in gross income as ordinary income, because the contract receives no step-up in basis at the owner's death.
Under IRC § 691, the gain in a non-qualified annuity at the owner's death ($140,000 less the $80,000 cost basis, or $60,000) is income in respect of a decedent and is taxable as ordinary income to the beneficiary; the contract receives no step-up in basis. The option that taxes the full $140,000 ignores the beneficiary's right to the decedent's cost basis. The option taxing the $60,000 gain as a long-term capital gain is wrong because annuity earnings are ordinary income, not capital gain. The option that exempts the entire distribution applies the step-up-in-basis rule that annuities do not receive, unlike stocks and mutual funds held at death.
A 70-year-old client used $150,000 from a taxable brokerage account to purchase an immediate fixed annuity. The contract will pay $12,000 per year for life. Using the IRS life expectancy tables, the client's expected return under the contract is $200,000.
What amount of the first year's $12,000 payment is excluded from the client's gross income? Answer: $9,000 is excluded and $3,000 is taxable, based on an exclusion ratio of 75%.
The exclusion ratio under IRC § 72 for an immediate non-qualified annuity is the investment in the contract divided by the expected return: $150,000 ÷ $200,000 = 75%. Applying 75% to the $12,000 annual payment means $9,000 is excluded from gross income and $3,000 is taxable in the first year, and each year after that until the $150,000 investment is recovered (about 16.7 years of payments, the client's life expectancy under the tables); for an annuity starting after 1986, later payments are fully taxable under IRC § 72(b)(2). The option excluding the entire $12,000 ignores the ratio and treats all payments as a return of principal. The option that reverses the ratio ($3,000 excluded, $9,000 taxable) applies the ratio to the wrong side of the payment. The option excluding the full $12,000 until the $150,000 basis is recovered states the post-basis-recovery rule correctly but the first-year exclusion incorrectly — the exclusion ratio applies from the first payment onward.
A 58-year-old client has a fully funded emergency reserve, participates in an employer-sponsored 401(k) plan, and has $50,000 that will be needed in 24 months for a child's college tuition. The client asks whether to invest the $50,000 in a variable annuity, noting that she will be 60 at withdrawal and the 10% early-distribution penalty will not apply.
Which assessment by the IAR is most appropriate? Answer: The variable annuity is unsuitable because ongoing contract fees and market risk prevent the account from guaranteeing the tuition payment in two years.
Under suitability standards applicable to a variable annuity recommendation, a fixed $50,000 need in 24 months makes the product unsuitable: ongoing contract fees, potential surrender charges, and market risk mean the amount available at the tuition due date is not guaranteed, and the tax-deferral benefit is generally not enough to overcome those costs over such a short horizon. The client's age at withdrawal does not cure those problems, because avoiding the 10% early-distribution penalty is only one cost consideration. The statement that the withdrawal is tax-free is wrong — earnings are taxed as ordinary income on withdrawal. The fixed-subaccount statement is wrong because a fixed subaccount does not eliminate contract fees and does not guarantee the tuition amount. The statement that the surrender period is the only problem and that principal is guaranteed is wrong because the variable separate account offers no principal guarantee and other costs can still reduce the amount available.
A client owns a variable annuity with an assumed investment rate (AIR) of 4%. In the most recent year, the separate account's gross return was 4.2%, and the contract deducted an annual mortality and expense risk fee of 1.1% of account value.
Assuming all other factors are unchanged, how will the client's next annuity payment compare with the prior payment? Answer: It will decrease, because the account's net return of 3.1% fell below the 4% AIR.
Variable annuity payout mechanics: payments are adjusted to reflect the separate account's net performance relative to the assumed investment rate (AIR). The net return is the gross return minus the mortality and expense risk fee: 4.2% − 1.1% = 3.1%. Because 3.1% is below the 4% AIR, the next payment decreases. The option that points to the gross return of 4.2% ignores the M&E fee. The option saying the payment stays the same assumes the AIR is reset annually, but the AIR is fixed at contract issue. The option stating the M&E fee does not affect the payment is wrong because the fee reduces account value and is reflected in the net return that drives the adjustment.
A 61-year-old client owns a non-qualified variable annuity with a cost basis of $100,000 and a current value of $180,000. The client asks whether the contract can be exchanged for a variable universal life insurance policy without recognizing the $80,000 gain.
Which statement is correct regarding the proposed exchange? Answer: The exchange is not a tax-free § 1035 exchange, so the $80,000 gain would be recognized as ordinary income.
IRC § 1035 permits a tax-free exchange of an annuity for another annuity, or of a life insurance contract for an annuity, but it does not provide nonrecognition for an exchange of an annuity for a life insurance contract. The proposed exchange therefore does not qualify for tax-free treatment, and the $80,000 gain is recognized as ordinary income under the annuity taxation rules of IRC § 72. The statement that the gain remains tax-deferred inside the life policy assumes a § 1035 exchange in the wrong direction. The same-insurer condition is not part of § 1035; exchanges between different insurers are permitted. The gain on a non-qualified annuity is not capital gain, so the long-term capital gain characterization is wrong.
A 57-year-old client owns a variable universal life insurance policy that is not a modified endowment contract. The policy's cash value is $80,000 and the client's cost basis is $30,000. The client borrows $45,000 from the policy.
Which statement correctly describes the consequences of the loan? Answer: The loan is not taxable in the current year, and any unpaid balance at death reduces the death benefit.
IRC § 72(e)(5): a loan from a life insurance policy that is not a modified endowment contract is treated as a loan, not a distribution, and is not taxable in the current year, even if the loan exceeds the policy's cost basis; the outstanding balance reduces the death benefit if it is not repaid. The option that taxes $15,000 (the excess of the loan over the $30,000 basis) treats the loan as a taxable distribution, which is true only for MECs. The option that says the loan has no effect on the cash value or death benefit is wrong because the loan is a lien against the cash value and reduces the death benefit. The option imposing the 10% early-withdrawal penalty applies the penalty that exists for annuities, IRAs and MECs, not for loans from a non-MEC life insurance policy.
- Which statement correctly describes a feature of variable life insurance?
Answer: The policyowner bears the investment risk, premiums go into separate subaccounts, and the death benefit stays at or above the initial face amount.
Variable life insurance is a security: premiums are invested in separate subaccounts, the policyowner bears the investment risk, the cash value is not guaranteed, and the death benefit has a guaranteed floor equal to the initial face amount. The option describing an insurer-guaranteed cash value funded through the general account describes whole (fixed) life insurance. The option that lets the death benefit fall below the initial face amount ignores the contractual floor. The option guaranteeing a minimum annual return equal to the assumed investment rate misreads the AIR: variable life uses an AIR as a benchmark for adjusting the death benefit and cash value, but it is not a guaranteed return, and the cash value has no guaranteed minimum.
- Which of the following statements is true regarding the federal income tax treatment of a non-qualified deferred annuity held by an individual?
Answer: The taxable portion of a withdrawal equals the amount of the contract's accumulated earnings deemed distributed first, and the balance is a tax-free recovery of the owner's cost basis.
Internal Revenue Code § 72(e) governs non-periodic distributions from a non-qualified annuity: earnings are treated as distributed first (LIFO), so the taxable portion of a withdrawal is the amount of the contract's accumulated earnings taken out, and the balance is a tax-free recovery of the owner's cost basis. The FIFO statement is wrong because FIFO applies to withdrawals from a life insurance policy that is not a MEC, not to annuity distributions. The statement that the 10 percent premature-distribution penalty is computed on the full amount distributed is wrong: the penalty under § 72(q) applies only to the portion includible in gross income. The statement that the tax-free portion continues for life is wrong: under § 72(b)(2), for an annuity starting date after 1986, the total amount excluded may not exceed the investment in the contract, so once the owner's cost basis is fully recovered, later payments are fully taxable. Tax-free for life is the pre-1987 rule.
- Which of the following statements is true regarding the assumed interest rate (AIR) in a variable annuity?
Answer: Payments after the annuity starting date are adjusted by comparing the separate account's net return with the AIR: level if equal, higher if above, lower if below.
This is a variable annuity payout mechanic. The assumed interest rate (AIR) is the return assumption used to convert the account value into annuity units and to adjust the value of each annuity unit after payments begin. If the separate account's net return equals the AIR, the unit value is unchanged and the dollar payment stays level; a return above the AIR raises the payment and a return below it lowers the payment. The statement that the AIR is a guaranteed minimum crediting rate confuses the AIR with the guaranteed rate of a fixed annuity; the separate account has no guaranteed rate. The statement that the number of annuity units is recalculated each month inverts the mechanics: the number of annuity units is fixed at the annuity starting date, and it is the value of each unit that fluctuates with performance. The statement that a higher AIR makes future increases easier is half right: a higher AIR does produce a larger initial payment, but it raises the performance hurdle, so future payment increases are less likely.
- Under the Uniform Securities Act, which statement correctly describes the treatment of annuity contracts as securities?
Answer: A fixed annuity is not a security, since the insurer promises a fixed sum, while a variable annuity is a security because the owner bears the investment risk.
Uniform Securities Act § 401 excludes from the definition of 'security' an annuity contract under which an insurer promises a fixed sum, so a fixed annuity is not a security; a variable annuity, whose value depends on the performance of the separate account and whose owner bears the investment risk, is a security. The option stating both products are securities ignores the fixed-sum exclusion. The option stating neither is a security confuses the exempt-issuer status of insurance companies with the product's status — variable contracts issued by insurers remain securities. The option that makes the variable annuity a security only in qualified accounts invents a distinction the Act does not contain; account type does not change the product's character.
- Under federal income tax law for tax year 2026, which of the following statements regarding an exchange of life insurance or annuity contracts is true?
Answer: A life insurance policy may be exchanged tax-free for an annuity contract on the same person, whereas an annuity contract may not be exchanged tax-free for a life insurance policy.
In tax year 2026, Internal Revenue Code § 1035(a) permits a tax-free exchange of a life insurance policy for another life policy, an endowment, or an annuity contract on the same person, and an exchange of one annuity contract for another, when the transfer is direct and the owner and insured/annuitant are the same. The reverse exchange, an annuity for a life insurance policy, does not qualify and is treated as a taxable surrender followed by a new purchase. The statement that an annuity may be exchanged for life insurance is therefore wrong. The statement that a variable annuity may be exchanged only for another variable annuity is wrong: exchanges between fixed and variable annuities are tax-free when the transfer is direct contract-to-contract and the owner and annuitant remain the same. The statement that both contracts must be issued by the same insurance company is wrong: direct transfers to a different insurer are tax-free, and the taxable result occurs when the owner receives the proceeds personally before purchasing the new contract.
A 52-year-old client invested $60,000 in a non-qualified variable annuity eight years ago. The contract is currently worth $95,000. The client withdraws $20,000 to make a down payment on a first home. The client is not disabled.
Which statement best describes the tax treatment of the $20,000 withdrawal? Answer: The full $20,000 is taxable as ordinary income, plus a 10% early-withdrawal penalty on the withdrawal.
IRC § 72(e) and § 72(q) govern non-qualified annuity distributions: withdrawals are taxed as earnings first (LIFO), and the 10% early-withdrawal penalty applies to the taxable portion before age 59½. The contract has $35,000 of gain ($95,000 − $60,000), so the entire $20,000 withdrawal is ordinary income and the penalty applies in full. The option treating the withdrawal as a nontaxable return of principal assumes FIFO ordering, which annuities do not use. The option that denies the penalty for a first-home purchase misapplies the IRA first-home exception, which does not extend to non-qualified annuities. The long-term capital gain option is wrong because annuity earnings are always taxed as ordinary income, regardless of holding period.
