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What is a Tax Sheltered Annuity?

Posted on March 24th, 2022
Fact checked by Daniel Cotter J.D.

Daniel Cotter J.D.

Daniel Cotter is an attorney with an expert in Annuity and Insurance Law. He graduated #1 in his class from the John Marshall Law School in 1994. He is currently the Attorney on record for Due. He is an expert and insurance regulatory and corporate governance including privacy.... Read More

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Are Annuities Taxable

Are you employed by an educational institution, church, or nonprofit? If so, there’s a retirement savings program authorized by section 403(b) of the Internal Revenue Code that allows eligible employees to set aside up to virtually 100% of their income for retirement.

What is a Tax-Sheltered Annuity?

An annuity that’s considered tax-sheltered is a way for employees of tax-exempt organizations and the self-employed to generate retirement income with pretax dollars. In addition, by having the employer make direct contributions to the plan, an employee is able to accumulate even more tax-free funds.

Generally, tax-sheltered annuities have provided dependable retirement income and have provided consistent payments over time.

An Overview of Tax-Sheltered Annuities

An example of a tax-sheltered annuity is the 403(b) plan in the U.S. Employees of specific nonprofit or public organizations may participate in this plan to save for retirement at a tax-advantaged rate. The maximum contribution an employee can make to the plan is usually a set amount. However, there are some plans where employees can make additional contributions to make up for the amount they did not contribute in previous years.

For the tax year 2021, the IRS will limit contributions to TSAs to $19,500. But, this will increase to $20,500 in 2022, matching the contribution limits of 401(k) plans. A TSA also offers a catch-up provision for participants 50 and older, which amounts to $6,500 in 2021 and $6,500 in 2022.

In addition, tax-sheltered annuities offer lifetime catch-up for participants. But, there is a catch. Thye must have worked at a qualified organization for 15 years or more and contributed no more than $5,000 during that duration. Moreover, the total contribution cannot exceed 100% of earnings up to a certain cap, including the contribution and catch-up provisions.

To withdraw from a qualified retirement plan, you must be at least 59 ½ years old. Unless certain exemptions apply, early withdrawals from most annuity types, including a TSA, are subject to a 10% IRS penalty. In addition, since the SECURE Act was enacted in 2019, withdrawals from IRAs are taxed as ordinary income, and they must start by the beneficiary’s 72nd birthday. Prior to that, withdrawals had to begin when the beneficiary turned 70 ½.

What’s more, employees may be able to borrow funds before reaching age 59 ½ — depending on the plan’s provisions. Additionally, a disabled employee may also withdraw from these plans as most qualified retirement plans allow it.

Tax-Sheltered Annuity Example

“The chief advantage of a TSA is that it can help reduce your taxes,” notes Bankrate. At a public university, Suzy is a professor of rhetoric. She earns $70,000 per year. Since her projected retirement age is 15 years away, she decides how much she will need to save each month.

“At retirement, Suzy expects to be making an annual income of about $100,000 a year, and would like to earn 75 percent of that amount once she has retired,” they add. She will generate nearly $60,000 a year from Social Security, her university pension, and saving, but she will still fall short of her goal by $15,000 each year. So, according to Suzy’s advisor, she should consider a TSA.

“To earn the $15,000 in additional annual income, Suzy’s advisor calculates a monthly contribution of about $700, for a total annuity of $210,000,” states Bankrate. In Suzy’s case, her employer contributes $700 to her retirement plan each month, which reduces her taxes by about $230 each pay period. With a TSA, Suzy earns income while spending only $470 out of her own pocket.

What Is a 403(B) Plan and How Does it Work?

403(b)s are retirement plans offered by nonprofit organizations and some tax-exempt employers, such as not-for-profits and some governmental organizations,” explains Due Co-Founder John Rampton. “A 403(b) plan is named after the section of the Internal Revenue Service (IRS) code for which they are designed.”

The Investment Company Institute reports that in 2018, approximately one in five U.S. employees had access to these accounts. Nonetheless, they receive less attention than their for-profit, private counterparts, 401(k) plans. The difference between a 403(b) and 401(k) is that eligible employees can contribute to their retirement fund through payroll deductions (also known as elective deferrals) based on a percentage of their pay or a budget they set.

“As an additional benefit, employers can also contribute to your accounts — aka matching contributions,” adds Rampton. “When you are ready to invest in the 403(b), be sure to invest at least that percentage of your employer’s match

403(b) plans are generally divided into two types: traditional and Roth.” It’s worth noting that not all workplaces offer the Roth version.

An employee’s personal retirement account is funded with pretax money deducted from their paychecks under a traditional 403(b) plan.

Furthermore, the employee has been able to save some money for the future and reduce their taxable income. It is only when an employee withdraws funds that taxes are due.

To establish a Roth 403(b), after-tax money must be contributed to the retirement account. As a result, tax benefits are not immediately gained. “However, when the money is withdrawn, the employee won’t have to pay any more taxes on that money or on the profit it accrues,” he adds.

Who Is Eligible for a 403(b) Plan?

There are some restrictions on who can sign up for a 403(b) plan. The plan is only open to specific organizations and institutions due to tax purposes.

According to Rampton, those who are eligible to participate in a 403(b) plan include:

  • Individuals who work for tax-exempt 501(c)(3) organizations
  • Public school, college, and university employees
  • Teachers employed by Indian tribal governments
  • Employees of cooperative hospital service organizations
  • Faculty and staff members at Uniformed Services University of the Health Sciences
  • 501(c)(3) ministers
  • A minister or chaplain whose primary job function is serving as a minister for a non-501(c)(3) organization
  • Self-employed ministers

According to the IRS, employers can exclude employees who work less than 20 hours a week from participating in a 403(b) plan.

Advantages and Disadvantages of Tax-Sheltered Annuities

You would need to weigh the pros and cons of using the TSA or tax-sheltered annuity account, such as your contribution flexibility. Depending on your situation, you can increase or decrease the number of contributions you make to a tax-sheltered annuity account, such as a 403(b).

Moreover, in the event that circumstances in an employee’s life or financial situation change unexpectedly, they may have access to optional loans and hardship distributions. Keeping in mind that your investment options might be limited by your employer is essential. As a result, you have little control over how your funds are invested. However, many of these plans offer a greater variety of investments these days, such as well-known mutual funds.

Advantages of TSAs and 403(b) Plans

  • Tax-deferred retirement savings.
  • Your employer handles the majority of the paperwork once you enroll at work.
  • Benefit from high annual contribution limits
  • Your annual taxable income is lowered when you contribute
  • At 50, you can make higher “catch-up” contributions than someone with a 401(k).
  • If you’ve worked at the same organization for 15 years or more, you can get a catch-up contribution of $3,000
  • Your fund might become yours sooner (a process called “vesting”). In addition, a few 403(b) plans allow you to access your funds immediately.

Disadvantages of TSAs and 403(b) Plans

However, these accounts come with some downsides as well.

You may find that your choice of investment options is an advantage or disadvantage depending on your experience. For example, a brokerage company can help you open a separate individual retirement account (IRA) if you want more options.

  • Withdrawal of funds before age 59 ½ will be subject to an additional 10% IRS tax.
  • The fees associated with these plans are usually higher.
  • 403(b) plans do not undergo nondiscrimination testing, meaning top management and highly compensated employees can reap the most rewards.
  • Employers are less likely to match 403(b) contributions than 401(k) plans.
  • The investment choices you have may be much more limited than those in a 401(k).
  • Funds invested in a 401(k) do not have the same protection from creditors as those invested in a 401(k).

Before enrolling in a TSA like a 403(b) plan, make sure to check the fees and costs involved.

Tax Sheltered Annuity Contributions

As a refresher, an IRS-approved tax-sheltered annuity, also known as a TSA or 403(b), is a retirement plan offered by public schools and some nonprofit organizations with 501(c)(3) tax-exempt status. Section 403(b) of the Internal Revenue Code allows employees to make pretax contributions to individual accounts up to a predefined limit each year.

The employee contributes via a deduction from their paycheck and places it directly into a tax-sheltered annuity account. This is typically accomplished by specifying the percentage or amount they would like to have deducted. In addition, employers can contribute to an employee’s account. Funds contributed to tax-sheltered annuities are tax-deferred until withdrawn, which typically occurs after one retires.

An employee who has withheld funds designated to a tax-sheltered annuity (TSA) typically has the option of choosing the investment products to which their money will be allocated. In most cases, employers pre-approve the products to be included in a plan.

Among the various options for annuity products, there are multi-year guarantee annuities, which earn a fixed and steady interest rate over time and fixed indexed annuities. In contrast, the latter link their interest earnings to an index rather than to the stock market’s performance.

Initially, TSA plans were specifically limited to annuity choices. The reason? At the time, annuities were mandated by law. The Employee Benefit Income Security Act of 1974 (ERISA) widened the selection of annuity products to include mutual funds. This was despite annuity products remaining the most popular option among tax-sheltered annuity plan participants.

Here is the complete annuity formula to understand the math behind each annuity plan.

TSAs vs. 401(k) Plans

TSAs are often compared to 401(k) plans. And, it’s easy to understand why.

Specific sections regulate both plans in the Internal Revenue Code that establish whether they can be used and whether they qualify for tax benefits. Also, each plan facilitates individual saving by allowing pretax contributions for tax-deferred accumulation of retirement savings.

After that, both plans differ. Mainly, 401(k) plans are offered to all eligible private sector employees working at companies with plans. On the other hand, a TSA plan is exclusive to employees of tax-exempt organizations and public schools. In addition, employers who work for nonprofit organizations with charitable, religious, or educational purposes can join TSA plans if they are qualified under section 501(c)(3) of the Internal Revenue Code.

Tax Sheltered Annuity In Retirement

You may annuitize a TSA annuity at any time once you have become eligible to receive distributions. To those not familiar with annuities, there are two phases. The first is the accumulation period, and this is followed by the distribution period.

TSA Withdrawal Rules

Before retirement, you may withdraw funds from your TSA only under the following situations:

  • Job termination
  • Disability
  • A financial hardship caused by medical bills or college expenses;
  • Death
  • In the case of a divorce, a qualified domestic relations order (QDRO) is required.
  • Deferrals of excess elective benefits

However, the contract may include surrender charges for withdrawals. And this can’t be stressed enough: withdrawals from a TSA before age 59½ will result in an IRS 10% early-withdrawal penalty and income taxes. But, you cannot be penalized by the IRS for withdrawals after age 55 if you terminate employment.

  • Loan Provisions. A TSA retirement plan loan may be available to you once per calendar year. Each loan must have a minimum of $1,000, and if you have another loan or an outstanding balance, your borrowing limit may be reduced.
  • Required Minimum Distributions. The IRS may not charge a surrender fee when you receive Required Minimum Distributions.
  • 90-24 Transfer. With this, it’s possible to change a tax-sheltered annuity (TSA) contract with another 403(b) contract. When in transition between jobs, for example, your employer is required to withhold 20% of any retirement savings funds distributed directly to you, leaving much less money to transfer into another qualified plan.

Frequently Asked Questions About Tax-Sheltered Annuities

1. How can I contribute to a TSA?

Employees can deduct contributions to their TSA or 403(b) through a payroll deduction. Contributions to TSA annuities must be taken directly from payroll. Your employer will be notified of your decision through a salary reduction agreement. A new salary reduction agreement can be completed to modify the number of your contributions.

2. How much can I contribute to a TSA?

There is an annual limit on how much can be deferred by the IRS and changes frequently. Participants over the age of 50 and employees who have worked for the same employer for over 15 years may be eligible for special catch-up provisions.

3. May I contribute from a checking or savings account?

Not at all. You must make your TSA 403(b) contributions via payroll.

4. When can I take money out?

If you are fully disabled or no longer with the organization, you can begin taking distributions from a 403(b) plan at age 59 ½. However, you can expect a 10% IRS penalty if you make withdrawals. If you have a financial hardship, you may be able to receive a distribution. Or, you may be able to take out a loan.

5. Who is a Plan Administrator?

To ensure compliance with IRS rules and guidelines, most school districts engage third-party administrators (TPAs) to manage their 403(b) plans.

John Rampton

John Rampton

John Rampton is an entrepreneur and connector. When he was 23 years old, while attending the University of Utah, he was hurt in a construction accident. His leg was snapped in half. He was told by 13 doctors he would never walk again. Over the next 12 months, he had several surgeries, stem cell injections and learned how to walk again. During this time, he studied and mastered how to make money work for you, not against you. He has since taught thousands through books, courses and written over 5000 articles online about finance, entrepreneurship and productivity. He has been recognized as the Top Online Influencers in the World by Entrepreneur Magazine and Finance Expert by Time. He is the Founder and CEO of Due.

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