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Bankrate glossary: Tax-Sheltered Annuity

Glossary

What is a tax-sheltered annuity?

A tax-sheltered annuity (TSA) is a retirement savings plan that allows employees to invest pretax dollars to build retirement income.

Many 403(b) plans offer tax-sheltered annuities. Eligible participants include employees working for tax-exempt organizations and public schools. Nonprofit organizations that qualify under 501(c)3 of the IRS code may offer TSA plans to their employees.

Tax-sheltered annuities are designed to provide consistent payouts over time and act as a reliable source of retirement income.

Employees' contributions are deducted from their income, allowing them to contribute to the annuities with pretax dollars. The investment grows without the burden of being taxed.

Taxes are paid on the annuity once the employee starts to draw an income from the investment.

Structuring annuities

Annuities can be structured in a variety of ways. They can provide income for a specific time period such as 25 years, guarantee payments for the annuitant's entire life and be structured to provide income to a surviving spouse if the annuity holder dies.

Fixed annuities offer regular payments for a specific time period.

Payments on variable annuities reflect the annuities' performance, paying a higher income if the annuity performs well and a lower income if the annuity performs poorly.

Which companies offer annuities?

While many companies market annuities, only insurance companies can issue them.

Banks, investment advisers, financial planners, mutual fund companies and estate officers can market annuities. However, they must carry an active life insurance license and a securities license.

It's important to note that brokers and planners earn a much higher commission on annuity sales than almost any other product they sell. Because of this, some financial professionals may be biased toward selling these products to clients.

Annuity advantages

The biggest advantage to annuities is that they offer a guaranteed payout, providing a consistent amount of retirement income to the annuity holder.

Annuities also are protected from probate proceedings and from creditors in most cases. Guaranteed payments can ensure annuitants have enough money to live comfortably through retirement and provide them with peace of mind.

Annuity drawbacks

Annuities cannot be liquidated easily. Annuity deposits are usually subject to surrender periods. If the annuity holder touches the money during the surrender period, which can last more than 10 years, he or she incurs a surrender fee.

Surrender fees can begin at more than 10 percent and gradually diminish each year during the surrender period.

In general, annuities often charge high fees. It's important to fully understand how much you're paying before selecting a TSA.

Contribution limits

TSA contribution limits are the same as 401(k) limits, and offer a catch-up provision for participants over 50 years old.

Participants who have worked for a qualifying organization for 15 years or more and averaged a contribution limit of $5,000 or less are eligible for lifetime catch-up.

Withdrawals

Annuity holders may begin taking withdrawals without being subject to penalties after age 59 one half. Withdrawals are taxed as ordinary income.

Participants must begin withdrawing from their annuity by age 70 one half. Some plans provide provisions for employees to borrow money from the fund before age 59 one half.

Employees also may be eligible to take early withdrawals if they become disabled.

The difference between TSA, 401(k), 403(b)

Like a 401(k) plan, a TSA is a tax-deferred plan that provides long-term investment for retirement savings. However, TSA plans are restricted to employees of tax-exempt organizations, while 401(k) plans are open to any private sector employee whose employer offers a plan.

The terms "tax-sheltered annuity" and "403(b)" often are used interchangeably. When the 403(b) was created in 1958, it was known as a tax-sheltered annuity because it only offered annuities. Over time, 403(b) plans have changed. While many 403(b) plans still offer tax-sheltered annuities, they now offer investments seen in 401(k) plans, including mutual funds.

Use this annuity calculator to determine the investment amount needed to generate a specific payment.



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