What is a Tax Sheltered Annuity?

The primary purpose of an annuity is to provide a guaranteed source of supplemental income during retirement. The various types of annuities have differing stipulations, but all types provide the benefit of ensuring a reliable stream of income. One such annuity is a tax-sheltered annuity. 

What is a Tax Sheltered Annuity? 

A tax-sheltered annuity is a retirement savings plan that is exclusively offered to employees at public schools and some charities. A tax-sheltered annuity plan gives employees the option to defer some of their salaries into tax-deferred investment accounts. The employee will not pay any taxes on their funds and any gains earned by their funds until they begin making withdrawals from the plan after age 59 ½. When the money is withdrawn, it is taxed as regular income.

A tax-sheltered annuity can also be referred to as a tax-deferred annuity (TDA) or a 403(b) retirement plan.

How Does a Tax Sheltered Annuity Work?

A tax-sheltered annuity (TSA) is a retirement savings plan that allows employees to invest pre-tax dollars in an account to build retirement income. Upon retirement, employees receive consistent annuity payouts from the account to give them a reliable source of income in retirement. The only people who are eligible to own a TSA are those who work for tax-exempt organizations (such as nonprofit organizations), public schools, or are self-employed.

Funding the TSA

When an eligible employee opts to open a tax-sheltered annuity, the account is typically funded in one of three ways: 

1. There is a salary-reduction agreement under which a portion of each paycheck that the employee receives is contributed to the TSA.
2. The employee personally makes payments to the plan that do not come out of their salary.
3. The employee makes payments to the plan and the employer matches these payments.

There is an annual limit on how much money can be contributed to the account, and it is usually the same limit that is placed on a 401(k) plan. The maximum amount an employee can elect to contribute out of salary to a 403(b) retirement plan for 2020 is $19,500.

Catch up Provisions 

Sometimes there are catch-up provisions that allow employees to make contributions to the account to make up for years when they did not maximize their contributions. The following are the two catch up provisions offered with a TSA: 

1. Age 50+ Catch-Up: Participants who are 50 years old and older are eligible to make additional annual contributions to the TSA plan starting when they turn 50. If a participant is already contributing the maximum amount to his or her plan, then he or she may also be able to contribute more with Catch-Up Contribution. However, there are catch-up contribution limits. 
2. Lifetime Catch-Up: Employees with at least 15 years of service can take advantage of this provision which allows participants to contribute up to $3,000 in addition to the normal contribution limit if they have previously contributed less than $5,000 a year to the plan on average. The lifetime limit for the catch-up provision is $15,000.

Taxes on a TSA

Taxes on TSA contributions and earnings are not levied until the plan owner begins to receive annuity payouts from the plan, at which point the payout money is taxed as regular income. Typically, withdrawals are not made until the plan owner is at least 59 ½ years old. If the plan owner makes a withdrawal before their retirement age, then he/she will have a 10% penalty. 

The Bottom Line 

Tax-sheltered annuities are similar to 401(k) plans in that both plans encourage individual savings by allowing for pretax contributions to a retirement plan on a tax-deferred basis. However, TSA plans are reserved for employees of tax-exempt organizations and self-employed people, while 401(k) plans are open to any private-sector employee whose employer offers a plan.

Special thanks in preparing this summary of “What is a Tax Sheltered Annuity?” goes to Bob Carlson, leader of the Retirement Watch advisory service and chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets.