Variable Annuities and 529 Plans

A variable annuity is a hybrid: part insurance contract, part investment. It offers tax-deferred growth and the option of lifetime income, but the investor, not the insurer, carries the market risk. That is the dividing line between a variable annuity and a fixed one.

The money goes into the insurer's separate account (kept apart from the company's general account), where it is invested in sub-accounts that work much like mutual funds. Because the return rides on those sub-accounts, a variable annuity is a security and must be registered, and selling one requires both a securities registration and a state insurance license. A few features define the product:

• returns rise and fall with sub-account performance
• growth is tax-deferred, with no tax until money is withdrawn
• surrender charges can apply to early withdrawals, and a 10% IRS penalty hits earnings taken before age 59½
• a death benefit typically guarantees beneficiaries at least the amount invested

A variable annuity moves through two phases, and the SIE tests the distinction closely.

During the accumulation phase, the investor pays in, the money is invested in sub-accounts, and growth is tax-deferred. The investor holds accumulation units whose total value rises and falls with the sub-accounts, and surrender charges may apply to withdrawals during the surrender period (typically 5 to 8 years, declining each year).

At the annuitization phase, the account value is converted into a stream of income payments, and the accumulation units become annuity units. Here is the key fact: once annuitization begins, the number of annuity units is fixed and never changes. What moves is the value of each unit, which rises or falls with sub-account performance measured against the assumed interest rate, the subject of the next part.

The assumed interest rate (AIR) is the benchmark the insurer uses to set each annuity payment during the payout phase, and the relationship is the most-tested point in the whole topic:

• if sub-account performance exceeds the AIR, the next payment rises
• if performance matches the AIR, the payment is unchanged
• if performance falls short of the AIR, the next payment drops

The comparison is always to the AIR itself, not to last period's payment, and the number of annuity units stays fixed throughout. Only the dollar value of each unit moves.

At annuitization, the investor picks a payout option, trading payment size against how long and to whom the income flows:

• Life only (straight life): the largest payment, paid for the annuitant's life and stopping at death with nothing to beneficiaries. The risk is an early death that forfeits the remaining value.
• Life with period certain: paid for life but guaranteed for a minimum stretch (say 10 or 20 years); if the annuitant dies within that period, beneficiaries collect the rest.
• Joint and survivor: paid over two lives (usually spouses), continuing until the second death, in exchange for a smaller individual payment.
• Period certain only: paid for a fixed number of years regardless of whether the annuitant lives, with no lifetime guarantee.

The trade-off is consistent: the more lives or guarantees a payout covers, the smaller each payment, because the insurer is on the hook longer.

Variable annuities are among the most expensive products on the exam, and the SIE expects the layers of cost:

• Mortality and expense (M&E) risk charge: pays the insurer for the death-benefit guarantee and administration, typically 1.0% to 1.5% a year.
• Administrative fees: flat annual charges for recordkeeping.
• Sub-account management fees: much like mutual fund expense ratios, often 0.5% to 2.0%.
• Surrender charges: back-end fees on early withdrawals, often starting around 7% to 8% and declining about 1% a year to zero.
• Rider fees: the cost of optional guarantees such as a guaranteed minimum income benefit, adding roughly 0.5% to 1.0%.

Stacked together, total annual costs of 2% to 3.5% are common, well above a mutual fund or ETF, which makes cost a central suitability question with these products.

A 529 plan is a tax-advantaged way to save for education, and on the exam it is classified as a municipal fund security regulated by the MSRB. There are two kinds:

• Savings plans invest contributions in mutual-fund-like portfolios, so the account value rises and falls with the market and the investor bears that risk.
• Prepaid tuition plans let a family lock in today's tuition rates at participating schools, with the state or institution bearing the risk.

The tax deal is the same for both: contributions are not federally deductible (though many states offer their own deduction), but the money grows and comes out tax-free when used for qualified education expenses. The account owner keeps control, not the beneficiary, and the beneficiary can be changed to another family member.

A side-by-side makes the savings-versus-prepaid choice clear:

5-year gift-tax averaging (superfunding)

A donor can front-load up to five years of annual gift-tax exclusions into a 529 in a single year ($90,000 per beneficiary in 2024) without triggering gift tax, by electing to spread the gift over five years, provided no further gifts go to that beneficiary during the period.

Non-qualified withdrawals

Money taken out for anything other than qualified education expenses is taxed as ordinary income on the earnings portion, plus a 10% penalty on those earnings.

Local government investment pools (LGIPs) let local government entities, cities, counties, school districts, pool their excess cash and invest it together, much the way a mutual fund pools retail money. They round out the trio of municipal fund securities the SIE groups together (alongside 529s and ABLE accounts under MSRB rules).

• they invest in short-term, high-quality debt, behaving much like a money market fund
• they give small entities access to diversification and professional management they could not get alone
• they are sponsored at the state level and tend to be highly liquid, with governments able to withdraw on short notice
• they are not open to individual retail investors, only to government entities

An ABLE account is a tax-advantaged savings vehicle for individuals with disabilities, the third type of municipal fund security. It works much like a 529: contributions grow tax-free, and withdrawals are tax-free when spent on qualified disability expenses.

Congress modeled ABLE accounts on 529 plans but added eligibility and balance rules the SIE likes to test.

Eligibility

• the disability must have begun before age 46 (raised from age 26 by the ABLE Age Adjustment Act, effective in 2026)
• the person must qualify for SSI or SSDI, or hold a comparable disability certification
• only one ABLE account is allowed per person

Contribution and balance limits

• the annual contribution limit equals the federal gift-tax exclusion ($18,000 in 2024)
• if the balance tops $100,000, the beneficiary's SSI cash benefits are suspended (not terminated) until it falls back below that line
• Medicaid eligibility is unaffected at any balance

Tax treatment

• contributions are not federally deductible
• earnings grow tax-free, and withdrawals for qualified disability expenses (housing, education, health, transportation, assistive technology) are tax-free
• non-qualified withdrawals are taxed as ordinary income on the earnings, plus a 10% penalty