Insurance Based Products

The whole unit on one sheet: annuity types, life insurance types, who bears the risk, and how each is taxed.

The One-Liners That Win Points

• "Variable" in the name = separate account = security. SEC registration plus a securities AND an insurance license. No "variable" means general account, insurer bears the risk, state regulation only.
• Fixed annuity: general account, insurer guarantees the rate, NOT a security. Its defining flaw is purchasing power (inflation) risk.
• Variable annuity: separate account, owner bears risk. Two laws cover it: the contract registers under the Securities Act of 1933; the separate account registers as an investment company under the Investment Company Act of 1940.
• Indexed annuity: general account with a guaranteed floor (typically 0 to 3%), NOT a security. Return-limiters: participation rate (slice you keep), cap rate (ceiling), spread (fee off the top), floor (safety net).
• Term life: death benefit only, no cash value, cheapest, not a security.
• Whole life: level premiums, guaranteed cash value in the general account, not a security.
• Universal life: flexible premiums, adjustable death benefit, general account, not a security. "Universal" means flexibility, not risk.
• Variable life and Variable Universal Life (VUL) are securities; VUL adds flexible premiums and is the highest-flexibility, highest-risk product.
• Life insurance death benefit is income-tax-free to beneficiaries; an annuity death benefit taxes the gain as ordinary income.

Numbers to Lock In

• 10% early withdrawal penalty on taxable amounts before age 59 1/2 (on top of ordinary income tax). Exceptions: death, disability, substantially equal periodic payments.
• Nonqualified accumulation-phase withdrawals use Last In, First Out (LIFO): earnings come out first, fully taxable; principal returns tax-free after.
• Nonqualified annuitization payments use the exclusion ratio (investment in contract divided by expected return); once premium is fully recovered, payments are 100% taxable.
• Qualified annuity distributions are 100% taxable as ordinary income.
• Annuities have no IRS contribution limits; earnings grow tax-deferred.
• 1035 exchange: tax-free, basis carries over, same owner, direct transfer. Goes "across or down" (life to annuity allowed), never "up" (annuity to life barred). Does NOT waive surrender charges.

Top Gotchas

• Fixed and indexed annuities are NOT securities; variable annuities ARE. The guaranteed floor on an indexed annuity means the owner bears no investment risk, even though returns track an index.
• Separate account vs. general account is the tell: separate account = owner risk = security = SEC; general account = insurer risk = state only.
• Accumulation vs. annuitization changes the tax rule AND the fees. LIFO governs accumulation-phase withdrawals; the exclusion ratio governs annuitization payments. Mortality and expense (M&E) charges run during accumulation only and stop at annuitization.
• All annuity gains are ordinary income at withdrawal, never capital gains, even a variable annuity that held equity subaccounts for decades.
• Life only pays the highest per period (one life); joint and survivor pays the lowest (two lives). The exam loves to reverse these.
• Policy loans are not taxable when taken, but a forgiven loan on a lapsed policy becomes taxable income; outstanding loans reduce the death benefit.
• Funding an IRA or 401(k) with a variable annuity is a classic unsuitable recommendation: redundant tax deferral plus extra fees and surrender charges.

One-Breath Recap

The word "variable" decides everything: variable annuities, variable life, and Variable Universal Life put money in a separate account where the owner bears investment risk, making them securities sold by prospectus and requiring both a securities and an insurance license, while fixed annuities, indexed annuities, term, whole, and universal life sit in the general account where the insurer bears the risk and only state insurance departments regulate. Annuity gains are always ordinary income, taxed LIFO on accumulation-phase withdrawals and by the exclusion ratio at annuitization, with a 10% penalty before age 59 1/2, whereas life insurance death benefits pass to beneficiaries income-tax-free. Know who bears the risk, know the account type, and every question on this unit sorts itself out.

Need more than the recap? This is a condensed summary. If it is not enough, read the full Insurance Based Products unit for the complete lesson.