Tax Sheltered Annuity

A tax-sheltered annuity (TSA) is an investment vehicle that allows an individual to make pre-tax contributions to a retirement account. Original TSA participants were restricted to annuities in their choice of investment instruments. Today the name is a misnomer because the menu of investment choice includes not only annuities but mutual funds as well. By far the best known and most popular TSA is the 403(b) plan, outlined in Section 403(b) of the IRS Code.

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The overarching purpose of the TSA is to extend the benefits of private-sector, company-sponsored retirement plans to those outside the sphere of such plans – public-sector educational employees, employees of non-profit companies and the self-employed, particularly ministers.

403(b) Tax Sheltered Annuity

IRS Code Section 403(b) singles out employees of educational institutions, 501(c)(3) non-profit institutions and self-employed ministers for special tax treatment. These individuals can make pre-tax retirement contributions from their employment earnings to “supplemental retirement savings accounts” called tax-sheltered annuities (TSAs). Original participants in the program were limited to annuities in their choice of investment vehicle. Today participants may invest in mutual funds as well as annuities. (The provision extending the range of choice to include mutual funds was Section 403(b)7 of the IRS Code.)

The TSA procedure is simple. The employee fills out and signs a “Salary Reduction Agreement,” specifying the magnitude and timing of monies withheld from salary. This enrolls the employee in the agreement. The employer has the right, but not the obligation, to make matching contributions to the employee’s TSA account.

TSAs are called supplemental retirement accounts because they are not intended to replace traditional retirement investments, only to add to them. Employees of many state educational institutions, for example, are eligible for a state government employee pension plan. Most people can draw Social Security benefits upon reaching age 65. Some people also have 401(k) or IRA accounts as well as TSAs. TSAs do not and were never intended to comprise the entirety of an employee’s retirement savings.

Advantages of 403(b) Tax Sheltered Annuities

403(b) plans offer numerous advantages to participants. These include:

  • They fulfill the need to supplement traditional sources of retirement income, such as Social Security. The Salary Reduction Agreement makes this convenient, while the combination of tax-deferred savings growth and lowered taxable income make the TSA highly productive for this purpose.
  • The ability to save while reducing taxable income is a tremendous boon. It is even possible that the reduction in taxable income might lower the participant’s marginal tax bracket, enhancing the tax reduction gains.
  • Achieving tax-deferred growth of principal and earnings is equally beneficial. Over the course of a savings lifetime, this can make a big difference in the size of the eventual retirement nest egg.
  • TSA plans usually offer flexible terms and low-cost investment alternatives. For example, it is easy to shift funds between plan investments that feature no sales loads or 12 (b)1 fees and low annual expenses.
  • TSA plans are portable; that is, the participant can retain the funds even after separating service from the sponsoring employer.
  • Contributions are credited to Social Security and pension earnings. This guarantees that 403(b) participation will not reduce the benefits from traditional social insurance or pensions, which are calibrated to employment earnings.
  • In addition to the $11,000 annual maximum TSA contribution, there is also a “catch-up” provision for people over age 50 allowing up to $5,500 in additional contributions.

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Disadvantages of 403(b) Tax Sheltered Annuities

TSAs have a few disadvantages. These include:

  • Investment gains are taxed as ordinary income. Since income taxes are much higher than capital gains taxes, this is a disadvantage relative to investments such as mutual funds.
  • As retirement vehicles, TSAs are subject to IRS penalties of 10% for premature withdrawals (prior to age 59 ½).
  • Some annuity hardship provisions, such as premium waivers in case of disability, may not be available in the TSA format.
  • The investment choices are somewhat restricted. In 1958, when the TSA as it exists today was first codified, the choice of an annuity was mandated. In 1974, the Employee Benefit Income Security Act (ERISA) broadened the choices to include mutual funds. Thus, the plan labors under both the limitations and drawbacks associated with these investment vehicles.

Suitability of the Tax Sheltered Annuity

403(b) plans have drawn much comment from the investment community, some of it adverse. Perhaps the most useful distinction to be drawn is one between comparison with an ideal, as opposed to an actual, alternative. For example, much is made of the fact that a disproportionate share of 403(b) investment has historically been placed in annuities, compared to mutual funds. The fact remains that even after the introduction of mutual funds onto the investment menu, participants continued to skew their purchases toward annuities. While a wider selection of investment choices would indeed be preferable, it is hard to be too critical of the decision to allocate pre-tax dollars to a safe investment that will supplement (or perhaps even replace) Social Security distributions during retirement. One wonders how many of the annuityholders bitterly regret their choice today, given the events of 2008-2009.

Criticism also falls upon the high expenses and ostensibly superfluous insurance features of annuities. In fact, one of the most popular annuity providers in 403(b) accounts is also one of the lowest-cost vendors of annuities. It is common to find that review committees, set up by employers, select and monitor the vendors of investment products to the plan in order to protect the interests of plan participants. This gives participants a clear chance to control their fate by lobbying for lower-cost investment choices, not just in annuities but in mutual funds as well.

One criticism that has at least partial validity is that annuities already provide tax deferral, which makes part of the benefit of a TSA redundant to an annuity investor. It is true that if a participant has an alternative source of pre-tax investment, such as a 401(k), it may well be superior to the 403(b). (The younger the participant, the more apt this is to be the case.) TSAs were originally established in order to provide retirement programs analogous to those in the private, for-profit sector. For those without access to the private-sector analogue, the TSA is certainly a desirable second-best solution.

Other Types of Tax Sheltered Annuity

In addition to the 403(b) plan, the 457(b) and 403(a) plan offer similar types of retirement investment benefits to different classes of beneficiaries. The 457(b) plan is open to employees of city and state governments, including public school employees, police and firefighters. It is also open to management and certain highly-compensated employees of tax-exempt private companies. Section 403(a), in addition to clarifying the rules for taxation of tax sheltered annuities, establishes that the self-employed also are eligible to set up a TSA for themselves.

In most respects, these plans are similar to the 403(b) plan in offering custodial and trust accounts in mutual funds and annuities.

Summary

Tax sheltered annuities, of which the 403(b) type is the best known, were set up to serve those outside the orbit of private-sector, company-sponsored retirement plans. These include employees of educational institutions, non-profit firms and the self-employed. The name is a misnomer because the investment choices include mutual funds as well as annuities, although annuities tend to be the most popular choice among participants. TSAs have a host of benefits and a few disadvantages. The benefits include pre-tax retirement saving and tax-deductible contributions that count in Social Security and pension earnings calculations, tax-deferral of principal and growth, plan portability and the chance to make “catch-up” contributions late in life. The disadvantages mostly flow from the limitations and drawbacks associated with the restriction to annuities and mutual funds.

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