What is a Tax-Sheltered Annuity?

Explanation

  • As per publication 571 (01/2019) of the Internal Revenue Service (IRS), the tax authority in the US, the Tax-Sheltered Annuity plan is for those employees who work for the specified tax-exemptTax-exemptTax-exempt refers to excluding an individual’s or corporation’s income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more organizations and falls under the terminology of 403(b) plansThe benefit is not given to those employees who are a part of the Roth IRA plan. In this case, the withdrawals are not taxable. The part of income contributed to this plan and the accumulated interest on the same are excluded from the taxable income, and only the remaining income is taxed. So basically, Roth IRA and TSA work diametrically opposite ways and are means of when the employee wants to pay the tax.The 403(b) plan is for certain eligible public sector employees who are a part of Non-profit organizations, while those part of for-profit organizations receive similar benefits from 401(k) accounts.

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How does Tax-Sheltered Annuity Work?

The 403(b) plan is in the hands of the employer, and employees can’t set it up on their own.

  • Eligible beneficiaries include government school or college employees, church employees, and the employees of charitable organizations covered under Section 501(c)(3) of the IRC.Employees and employers can contribute to the account.Withdrawal before the allowable date attracts a 10% penalty.The annual contribution was limited to USD 19,000 in 2019 and increased to USD 19,500 in 2020.There is a provision to make additional contributions for the years in which the contribution was lower than the upper limit.The total contribution is limited to USD 57,000 for 2020, which was USD 56,000 in 2019; this includes employer and employee contributions.If an employee has more than one retirement savings plan, the combined annual total contribution should be per the prescribed limit of USD 19,500 for 2020.

Tax-Sheltered Annuity Plan

Under the tax-sheltered annuity 403(b) plan, there are various methods of making contributions, based on which the following terminology has been defined:

  • Under Elective deferral, the employer deducts his contribution from the employee’s salary and direct depositsDirect DepositsDirect deposit is a technique of sending money from the payer’s account to the payee’s account digitally, without any paper cheques. For example, companies use it to transfer salaries into their employee’s accounts.read more into the savings account. Roth contributions are taxable while withdrawals are not, while it is the opposite for 403 (b) contributions.The non-elective contribution is the employer contribution, which matches that of the employee or is discretionary or might even be mandatory. These don’t reduce the salary and are not taxable until withdrawn.At times plans even allow after-tax contributions, and thus the withdrawal of these is not taxable.There can even be plans that combine features of all of the above and are sometimes known as a hybrid variant.

Withdrawal of Tax-Sheltered Annuity

Distribution of the accumulated funds can be made at the occurrence of the following events:

  • Once the employee reaches the age of 59 years and 6 months.Has been untimely severed from his employment;Death of the employee, in this case, his legal heirs, receives the payment.Physical or mental disability.The described financial hardship would allow distribution if the contribution were made under the effective deferral program.

These withdrawals are taxable entirely under the ordinary incomeOrdinary IncomeOrdinary income refers to an individual’s or business entity’s earnings that are taxable at the regular rates. Such earnings include salary, wages, rent received, royalty, commission, interest received, profit, etc. It excludes all incomes with tax deducted at source and capital gain.read more head except if the payments were made to the Roth account.

  • A minimum limit amount of interest, if not the entire amount accrued post-1986, should be withdrawn by April 1st of the year when the employee reaches the age of 70 years and six months or when he retires, whichever falls on a later date. The interest amount can be transferred to another employee under the contract exchange provision, and this transfer is tax-free. However, several conditions must be met for such a transfer post-September 24, 2007.Instead of withdrawing, accumulated funds can be rolled over to a Roth IRA at the end of the TSA as per the specified rules. Such rollovers get taxed in that year.

Advantages

  • The contribution is not taxed in the early years of a person’s career when he is building up his financial position, which helps him pay lower taxes and have higher disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes.read moreAn employer also contributes to the fund, which at times is mandatory for them; this leads to a greater accumulated corpus available at the time of retirement to support the retiree in his old age.If all conditions are met, then the interest transferred at the time of retirement is also tax-free, and therefore the tax is deferred to an even later time.When the employee faces financial hardships, which fall under the described category, the employee can withdraw the amount without paying a 10% penalty on premature withdrawal.Finally, as with all retirement plans, some income is saved for the future, securing retirement needs.

Disadvantages

  • At times the tax slab revision might be detrimental, and uncertainty regarding the same becomes a problem because, at the time of withdrawal, the tax rates might be higher than when the contribution was made.Premature withdrawal attracts a penalty as per the described rules of the account. Therefore, gathering proof that such a penalty doesn’t apply in certain cases becomes tedious and causes stress when there is an urgent need for funds.There are caps on the maximum amount that can be contributed to such an account, and the excess amount gets taxed.Further, calculating the maximum contribution based upon the given income, if it is below the maximum allowable limit, requires in-depth knowledge of tax law and therefore requires hiring a tax consultant, which can be time-consuming and costly.

Conclusion

  • In the end, the TSA is a form of deferring taxesDeferring TaxesDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid.read more to a later point in time where the beneficiary has a greater ability to pay the same. Till the time the amount is not withdrawn, it is not taxed. Interest accruedInterest AccruedAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period.read more during the account before retirement is not taxed either; however, the interest accrued post that is taxable.Most countries have similar plans for their people, and understanding one may give an overview of understanding those in different countries. One can acquire an in-depth understanding of the country’s tax rules applicable to the employee.

This has been a guide to What tax-sheltered annuity is & its Definition. Here we discuss the tax-sheltered annuity 403(b) plan and how it works, along with its advantages and disadvantages. You can learn more about it from the following articles –

  • Transfer TaxTax BreakTax ShieldWithholding Tax