Quick Answer
A variable annuity is both a security (registered under the Securities Act of 1933 and the Investment Company Act of 1940) and an insurance contract. The separate account holds the investments and the owner bears the risk; the general account backs the guarantees. Gains are always ordinary income, taxed LIFO, tax-deferred but never tax-free.
The whole unit on one sheet: the dual nature, the separate account, how units are valued, the payout options, and the tax lines the exam loves.
Core Concepts First
- Variable annuity = security AND insurance. Registered under the Securities Act of 1933 and the Investment Company Act of 1940; also an insurance product. Selling it needs a securities license (Series 6 or 7), a state insurance license, and association with a broker-dealer.
- The contract owner bears the investment risk. Value fluctuates with separate account performance, unlike a fixed annuity.
- Separate account holds the investments, is registered as an investment company, and is protected from the insurer's creditors. General account backs the guarantees (death benefits, living benefit riders) and is where insurer solvency matters.
- Two phases: accumulation (pay-in, uses accumulation units) and annuity (payout, uses annuity units).
The One-Liners That Win Points
- Separate account = where the risk lives. General account = where the guarantees live. Guarantees depend on the insurer's claims-paying ability.
- Accumulation units: number AND value change (number rises with payments, value moves with performance). Annuity units: number is fixed at annuitization, value fluctuates.
- Annuitization is irrevocable. Once annuitized, the owner cannot surrender or make changes.
- Payments vary in the annuity phase because the value per annuity unit changes, measured against the Assumed Interest Rate (AIR). Earn exactly the AIR = level payments; beat it = payments rise; fall short = payments fall.
- Subaccount transfers are NOT taxable. A withdrawal or full surrender IS.
- A tax-free insurance-product exchange (a 1035 exchange) is a one-way street: Life Insurance to Endowment to Annuity. Move right, never left; an annuity can never become life insurance tax-free.
- Tax-deferred, not tax-free. Gains are always ordinary income, never capital gains, no matter how long held.
- "Variable" = separate account = security = prospectus required. Whole life and universal life are insurance only.
Numbers to Lock In
| Item | Value |
|---|---|
| Early-withdrawal tax penalty | 10% of the taxable portion |
| Age threshold for the penalty | before age 59 1/2 |
| Mortality and Expense (M&E) risk charge | 1.00 to 1.50% of account value per year |
| Surrender charge (Contingent Deferred Sales Charge, CDSC) | 6 to 8%, declining to 0% over 6 to 8 years |
| Free withdrawal allowance | up to 10% of account value per year |
| Living benefit rider charges | 0.50 to 1.50% of benefit base per year |
| GMWB (Guaranteed Minimum Withdrawal Benefit) rate | typically 4 to 6% for life |
| Principal review of a deferred variable annuity | 7 business days after OSJ receives a complete application |
| Prior deferred variable annuity exchange look-back | 36 months |
| Commission returned if surrendered within | 7 business days of purchase |
| Non-cash compensation gift limit | $300 per year per person |
Payout Options (More Protection = Lower Payment)
- Life only (straight life): highest payment; nothing to beneficiaries at death.
- Life with period certain: guaranteed minimum period; beneficiary gets the rest if the annuitant dies early.
- Joint and last survivor: lowest payment; continues until the last of two annuitants dies.
- Unit refund (cash refund): if the annuitant dies before payments equal the contract value, the beneficiary receives the difference.
Top Gotchas
- Guarantees come from the general account, not the separate account. If the insurer becomes insolvent, the death and living benefits may not be honored.
- Surrender value is NOT contract value. Surrender value is reduced by CDSC and outstanding policy loans.
- The AIR is a benchmark, not a minimum guaranteed return. Underperform the AIR and payments decrease; earn exactly the AIR and payments stay level (not rising).
- LIFO: earnings come out first and are taxed as ordinary income; only after all earnings are withdrawn does the tax-free basis come out.
- Surrender charges reduce your check but NOT your tax bill. A $100,000 contract with a $60,000 basis and a $5,000 surrender charge pays $95,000 but is taxed on the full $40,000 gain.
- Annuities get NO step-up in cost basis at death; the beneficiary pays ordinary income tax on the earnings portion.
- Qualified annuity withdrawals are 100% taxable (no LIFO distinction, since all contributions were pre-tax).
- Variable life has a guaranteed MINIMUM death benefit (face value floor) but NO guaranteed minimum cash value; cash value can fall to zero while the death benefit never drops below face value.
- VUL has flexible premiums; VLI has fixed premiums. A "fixed premium variable policy" is VLI, not VUL.
- Principal approval must come before transmittal, and the 7 business days is a deadline, not a waiting period.
- The 36-month look-back applies to exchanges, not initial purchases, and a new surrender period restarts on the replacement contract.
One-Breath Recap
A variable annuity is a security and an insurance contract at once: the separate account holds the investments and the owner bears the risk, while the general account backs the guarantees. Accumulation units change in number and value, annuity units are fixed in number but fluctuate in value against the AIR, and annuitization is irrevocable. Tax it LIFO as ordinary income, deferred but never free, with a 10% penalty before age 59 1/2.
Need more than the recap? This is a condensed summary. If it is not enough, read the full Variable Annuities and Life Insurance unit for the complete lesson.