Retirement Plans and Annuities: Practice Questions & Explanations

An annuity is a contract with an insurance company that provides periodic payments to the annuitant. Where life insurance addresses the risk of premature death (paying when the insured dies too soon), an annuity addresses the risk of outliving one's resources (paying as long as the annuitant lives). Two phases: (1) Accumulation phase — premiums paid in, value grows tax-deferred; (2) Payout (annuitization) phase — periodic income payments to the annuitant. Types: immediate (payments begin right after a single premium) versus deferred (accumulation period before payouts begin); fixed (guaranteed rates of growth and payment) versus variable (returns depend on investment subaccount performance) versus indexed (linked to a market index with floors and caps).

A 'qualified' retirement plan is one that meets specific Internal Revenue Code requirements that grant favorable tax treatment: pre-tax contributions (reducing current taxable income), tax-deferred growth (no taxes until withdrawal), and tax-deductible employer contributions. Examples: 401(k), 403(b), traditional IRA, SEP-IRA, SIMPLE IRA, defined benefit pension plans. Qualified plans have contribution limits, distribution rules (typically taxable at withdrawal, penalty if before 59½, required minimum distributions starting at age 73), and may require nondiscrimination testing. Non-qualified plans (deferred compensation, executive bonus plans, non-qualified annuities) have more flexibility but no upfront tax deduction. Roth IRAs and Roth 401(k)s are 'qualified' but use after-tax contributions for tax-free withdrawals.

SECTION 1035 OF THE INTERNAL REVENUE CODE allows tax-free exchanges of certain insurance and annuity products. PERMITTED 1035 EXCHANGES: Life insurance → life insurance (same insured); Life insurance → annuity (tax-deferred); Annuity → annuity (same annuitant); Endowment → annuity. NOT PERMITTED: Annuity → life insurance. WHY THIS MATTERS: Without 1035 exchange treatment, any gain in a policy's cash value above the cost basis would be taxable as ordinary income when the policy is surrendered; 1035 allows the policyholder to move into a newer, better product without paying income taxes on the accumulated gain. REQUIREMENTS: Must be a direct transfer — the policyholder cannot receive the cash; the insurance company sends the funds directly to the new carrier; both policies must be on the same insured (life insurance) or annuitant (annuity); the new policy cannot have significantly different ownership; WATCH FOR: Surrender charges on the old policy that may still apply even with a 1035 exchange — the exchange doesn't eliminate surrender charges, only the income tax on gain; COMPARISON TO TAXABLE SURRENDER: If a policyholder surrenders a policy with $50,000 of gain directly (not 1035), they owe income tax on $50,000; with a 1035, the gain transfers into the new policy and is not taxed until a future surrender or distribution. AGENT RESPONSIBILITY: Explaining 1035 exchange options is part of professional service when discussing policy replacement.

NON-QUALIFIED DEFERRED COMPENSATION (NQDC) is a promise by an employer to pay compensation to a key employee at a future date (retirement, death, disability, or separation). CONTRAST WITH QUALIFIED PLANS: Qualified plans (401k, pension) follow ERISA, offer tax deductions to employer, are pre-funded, and have contribution limits; NQDC plans: do NOT follow ERISA, no contribution limits, employer deduction occurs only when employee receives the income (not when the promise is made), and are NOT pre-funded in the traditional sense — the employee has only an unsecured promise. RABBI TRUST: A common NQDC funding vehicle — assets are set aside in trust but remain accessible to the employer's creditors in bankruptcy; the arrangement provides informally secured funding without triggering current taxation to the employee. LIFE INSURANCE IN NQDC: Many companies use COLI (corporate-owned life insurance) to informally fund NQDC obligations; the policy's cash value grows tax-deferred, providing funds to pay the deferred compensation when due; the death benefit also funds the obligation if the executive dies before retirement; this is an informal arrangement — the policy is a corporate asset, not formally allocated to the employee's benefit; RISKS TO EMPLOYEE: The NQDC promise is an unsecured obligation — if the company becomes insolvent, the executive is a general creditor; the life insurance inside a rabbi trust is also available to creditors; this is why NQDC is primarily used for highly compensated executives who can tolerate this risk.

An annuity is a contract between an individual and an insurer designed primarily to provide a stream of income, often during retirement. In a sense it is the opposite of life insurance: life insurance protects against the financial risk of dying too soon (leaving dependents without support), while an annuity protects against the risk of living too long and outliving one's savings, by providing income that can last for life. Annuities have accumulation and payout (annuitization) phases and come in fixed and variable forms. Understanding the income-providing purpose of annuities, and how it contrasts with life insurance, is standard retirement-topic content.

A fixed annuity credits a guaranteed (or minimum guaranteed) interest rate and provides predictable, stable payments; the insurer bears the investment risk. A variable annuity lets the owner allocate funds among investment subaccounts (similar to mutual funds), so the account value and the resulting payments rise and fall with market performance, and the owner bears the investment risk. Because variable annuities are tied to securities, agents selling them generally need a securities license in addition to an insurance license. Understanding the risk and return difference — fixed (guaranteed, insurer's risk) versus variable (market-based, owner's risk) — is a commonly tested annuity distinction.