Example
Eric and Audrey, both 50 years old, have a $100,000 Certificate of Deposit maturing next month. Both are actively employed and their take home salaries combined are $10,000 a month. Fortunately, they have six months’ income, $60,000, in a money market account established for emergencies. They also have another $100,000 in an IRA at a bank yielding 1%. Their financial professional has asked Eric and Audrey a series of questions designed to determine their tolerance for risk, their time horizon, their needs, and their current portfolio. Based upon the answers to those questions, the financial professional has recommended that the entire IRA at the bank be rolled over to a variable annuity with a Rachet Death Benefit and that $50,000 of the $100,000 CD, which is maturing next month, be equally divided among a traditional fixed annuity, a fixed annuity guaranteeing 4.5% for five years, and an equity-indexed annuity.
Eric and Audrey have asked their financial professional what the tax consequences would be if they do withdraw or surrender both their IRA and their non-qualified annuity in the event that an emergency arose and they needed more than the $60,000 that they had set aside
Their financial professional responded accurately by saying all dollars withdrawn from the IRA (prior to age 59.5) would be subject to ordinary income taxes plus a 10% federal excise tax penalty. For example, a $50,000 distribution from the IRA would trigger ordinary income taxes of $16,500 (based on 33% tax bracket) and a federal excise tax penalty of $5,000 (10% times $50,000). Regarding the non-qualified annuities, 100% of all earnings would trigger ordinary income taxes plus a 10% federal excise tax penalty. So, if the non-qualified annuity had a surrender value of $75,000 at the time of emergency, the earnings, $25,000, would trigger ordinary income tax of $8,250 (33% of $25,000) plus a 10% federal excise tax penalty of $2,500 (10% of $25,000). Naturally, the balance, $50,000, would not be taxable (but subject to a surrender charge) since it is principal.
Based on those answers and concerns, the financial professional and Eric and Audrey decided that the $60,000 emergency fund in the money market account and the $50,000 being kept at the bank gave them over one year’s income, which was more than enough if an emergency were to arise.
What can be learned from this example? Eric and Audrey followed the financial professional’s advice because it embraced diversification, provided liquidity, and the financial professional was well versed on the topic of annuities.
