Tax Sheltered Annuities | What Are They and Who Are They For?

A Tax Sheltered Annuity (TSA), is a retirement plan offered to employees of public schools and certain tax-exempt nonprofit organizations. It is also known as a 403(b) retirement plan and can be compared to a private company's 401(k) plan as both offer great platforms for tax-deferred retirement savings.

What Is a Tax Sheltered Annuity?

The IRS allows employees of tax-exempt organizations to have access to a TSA. The TSA is provided and administered by the organization or institution and can be a solid foundation to a robust retirement plan. Participants can, of course, make other investments outside of the TSA, but the core benefits of a TSA that make it convenient are the payroll deduction and "set it and forget it" features.

Technically speaking, as an employee of one of these organizations, section 403(b) of the Internal Revenue Code allows you to save for retirement by making pre-tax contributions–up to a predefined annual limit–to individual accounts within a TSA.

You contribute to the TSA by specifying an amount or percentage that you would like to have withheld from your paycheck and deposited to your TSA account. This is called an "elective deferral" or a salary reduction agreement. Elective deferrals are exempt from income tax, although employees must pay Medicare and Social Security tax on these contributions.

Employers can, and usually do, make additional contributions to employees’ TSA accounts.

Are All Tax Sheltered Annuities 403(b) Plans?

In short, no. Most 403(b) plans offer investment options that can include mutual funds and annuities. When the 403(b) was invented in 1958, it was known as a tax sheltered annuity.

Today, TSA plans offer a full suite of mutual funds similar to those available in 401(k) plans, and many still offer annuities. Financial advisors often recommend against investing in annuities within a 403(b) and other tax-deferred investment plans for a variety of reasons:

• Annuity contracts are designed to provide tax-deferred earnings growth, but since TSAs already offer that feature, investing in an annuity that is designed to provide the same feature seems redundant.
• Some investors may not have the time, patience, or knowledge to evaluate the different types of annuities that may be offered in 403(b) plans.
• Some annuities, especially variable annuities, charge high fees. These fees detract from investment performance.
• Finally, variable annuities have a payout based on the performance of underlying investments and can lose money. Investing in an overpriced vehicle that can lose money may be a poor investment decision.

There are more conservative versions of annuities that you can purchase within your 403(b) plan. These are called fixed annuities. These annuities offer a guaranteed payout in retirement. If you are a conservative investor and your 403(b) offers a fixed annuity, it may be a good place to put a portion of your money.

Who Should Choose a Tax Sheltered Annuity?

If you are an employee of a tax-exempt organization or school, a TSA can be a valuable part of your overall retirement plan. But TSAs are considered supplemental retirement accounts. They are not intended to be the sole vehicle in your retirement plan. In fact, many public school employees are eligible for and participate in state governed pension plans. If you are eligible for this type of pension, then TSA plans allow you to defer and save additional funds on a tax advantaged basis for retirement. It is supplemental to your pension plan.

Also, if the concept of portability and flexibility are important to you, then a TSA may be a good plan choice. Portability simply means that you can take your plan with you if you leave your job because of termination of employment or retirement, your TSA can roll over to an individual retirement account (IRA) or other qualified retirement plan.

If you decide to participate in a TSA, you will need to understand the rules around contributions and contribution limits.

Contribution Rules

Contributions to a 403(b) account depend on your annual Maximum Amount Contributable (MAC). Maximum contribution rules can be complex, but the IRS provides a worksheet to help you better understand the calculation. Broadly speaking, however, your MAC rests on two major limits:

1. Limit on annual additions. This is the limit on all employer and employee contributions that can be made on your behalf, including any after-tax contributions.
2. Limit on elective deferrals. This is the amount you are allowed to contribute to your 403(b) plan through your salary-reduction agreement. If you contribute to other retirement accounts, such as a separate IRA plan, you must include contributions to all of these accounts to determine your annual 403(b) limit.

There are some exceptions to these contribution rules. If you have 15 years of service with an educational organization, church, or other eligible nonprofit organization, and your employer's plan documents allow, you may be able to increase your annual elective deferral.

Like the MAC calculation, however, this depends on pretty specific calculation rules – in this case, concerning the definition of "years of service." So it's helpful to use the IRTS worksheet mentioned above, to see if you qualify for this additional contribution.

Also, 403(b) plans also contain provisions for "catch-up" contributions for those who start saving later in their careers. If your employer's plan allows for catch-up contributions, you've reached age 50 by year-end, and you've maxed out your elective deferrals contributions, you may be eligible to contribute more than the maximum.

Here's a "for instance." Let's say you're over the age of 50 and also meet the 15 years of service requirements. The good news is that you can take advantage of both deferral increases! In figuring the total, you allocate deferrals under the 15-year rule, and then allocate to the age 50 catch-up provisions.

Pros of a Tax Sheltered Annuity

Flexibility – You can increase, decrease, or even stop and then restart your contributions to the plan depending on your financial situation.

Loan and financial hardship provisions – If you need access to the money in the account prior to retirement, these plans give you the ability to take out loans against the balance and pay yourself back. Hardship provisions may allow you to take withdrawals with reduced penalties.

A range of investment choices – While limited by the employer, most TSAs offer a solid variety of investment choices like mutual funds, annuities, and exchange traded funds (ETFs)

Cons of a Tax Sheltered Annuity

High fees – Some investment choices, like variable annuities, can take a chunk of your investment gains away in the form of fees. Even mutual funds can be heavy handed with annual fee charges, so make sure you ask about the fees associated with any investment choice within the TSA.

Salesperson tactics – Some organizations that offer TSA plans will invite you to meet with a salesperson to review your investment choices. Many of these people work on commission, so be sure to focus on fees and the possibility of loss within the investment.

The sole retirement savings vehicle – Some employees may be tempted, because of the ease of signing up for these plans, to make a TSA the only retirement savings vehicle for their retirement savings plan. Having only one platform for saving for retirement is not a good idea, and individuals should consider adding a variety of risky and more conservative products to round out their portfolio.

Is a Tax Sheltered Annuity Right for You?

If you are employed by a school, non-profit or other 501(c)3 organization, then participating in a TSA can be an excellent part of our overall retirement plan.

Adding other products like fixed annuities can be a good idea as well because fixed annuity crediting rates offered by insurance companies are guaranteed. Canvas annuities, for example, offer very attractive rates on a variety of fixed annuities. These annuities can be purchased online in minutes or with the help of a licensed call center agent.