All about tax-sheltered annuities
Employees of public school systems, charitable organizations and other non-profit organizations have a unique retirement plan option called a tax-sheltered annuity (TSA). Also known as a 403(b), this plan is similar to a 401(k), with a few exceptions.
How tax-sheltered annuities work
A TSA is provided by your employer. You make pre-tax contributions from your employment earnings, which are deposited in a retirement account. Just as with 401(k) plans, a participant’s employer can also contribute to employees’ 403(b) plan. You then designate how you want those funds invested, based on the options provided by the plan sponsor.
According to the IRS, employees of the following types of organizations can participate in a tax-sheltered annuity:
Tax-exempt organizations known as 501(c)(3) non-profits
Public school systems
Cooperative hospital service organizations
The Uniformed Services University of the Health Sciences (USUHS)
School systems organized by Indian tribal governments
In addition, ministers who are self-employed, or who work as ministers in their day-to-day professional responsibilities with their employers are eligible.
If you leave your employment, you’re permitted to roll over any part of your otherwise taxable eligible distribution from a 403(b) annuity into another retirement plan. Likewise, if you are entering employment with an eligible 403(b) plan and have money is another retirement plan from a previous employer, you can roll over those funds into your new plan.
Just as with a 401(k) or IRA, there are annual contribution limits on 403(b) plans. Employees under the age of 50 can contribute no more than $18,000 in 2015. Those over 50 can add up to $24,000 annually.
The annual contribution limit includes money deposited in another retirement plan, such as a 401(k) or SiMPLE IRA. Essentially, the total you contribute to all retirement plans cannot exceed the above annual limits.
There is also a limit to the total amount contributed by the employee and employer. For 2015, the cap is the lesser amount of:
100% of includible compensation for the employee’s most recent year of service
One unique contribution provision TSAs can offer is a higher contribution limit for employees with 15 years or more of service to their employer. The annual individual deferral limit increases to the lesser of:
$15,000, reduced by the amount of additional elective deferrals made in prior years because of this rule; or
$5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for earlier years.
TSAs typically provide many of the same investment options as a 401(k), including mutual funds, bond funds, real estate funds, and money market accounts. Unlike a 401(k), TSA participants do not have the option of investing in individual stocks.
How tax-sheltered annuities are taxed
Unlike regular annuities, TSAs allow you to make pre-tax contributions into the plan, similar to 401(k)s and IRAs. Taxes are also deferred on the plan’s earnings. Your withdrawals from the plan will then be taxed as ordinary income. In addition, you will be assessed a 10 percent tax penalty for withdraws before age 59 1/2 (there are exceptions; see below).
Some plan sponsors also provide a Roth 403(b) option. Under these plans, your contributions are made on an after-tax basis. However, the earnings on your accounts’ growth will not be taxed, and most importantly, the income from your plan will be free of taxation, provided you do not begin withdraws until at least age 59 1/2.
Generally, you must begin taking minimum withdrawals from your account when you retire, or by April 1 following the year in which you turn age 70½, whichever is later. Depending on the plan you are enrolled in, you could have some or all of the following options when it’s time to withdraw retirement income:
Lifetime income. Unlike 401(k) plans, a 403(b) plan offers the option of taking lifetime income. The amount of income you receive will be based on the account value, your age when you begin taking withdrawals and whether the annuity will continue payouts for the life of your surviving spouse. You may also have the option of including a minimum guaranteed period that will insure the payments continue to your beneficiaries for a certain period if you die (and your spouse if it’s paying out for two lives) before the end of that period.
Retirement transition benefit. Some TSAs allow you to take a percentage of your accumulation, say, up to 10 percent, at the beginning of a conversion to lifetime income. Using this benefit will reduce the amount of lifetime income, but can help with the transition from having a regular paycheck to living off retirement benefits.
Systematic withdrawals. If your plan allows, you can choose to receive regular income payments on a semimonthly, monthly, quarterly, semiannual or annual basis. Many plans will allow you to increase, decrease or suspend the payments at any time. There is typically a minimum amount you must take.
Lump sum. Some TSAs will allow you to take all or part of your account in a single cash payment. Other plans may restrict this option to 10 annual payments.
Withdrawals before 59 1/2
In most cases, withdrawing money from the TSA prior to age 59 1/2 will result in a 10 percent tax penalty, plus the normal taxation of income. There are certain cases where you will not be charged a tax penalty, including:
Hardship distributions. Some plans may permit you to receive money from your TSA prior to 59 1/2 if you endure a heavy financial need. In most cases, you will have to stop deferring income into the TSA for a set period.
Distribution for active reservist. The penalty for early withdrawals will not apply to a qualified reservist, defined as an individual who is a reservist or national guardsman and who was ordered or called to active duty for a period in excess of 179 days or for an indefinite period. To escape tax penalty, the withdrawal must be made during the call-up period.
Loans. Loans may be available under the 403(b) plan. There is usually a minimum and maximum amount you can loan yourself from the plan. You will repay the loan with your contributions into the plan. If you default on your loan or it fails other conditions, the IRS may treat your loan as a taxable distribution. Your loan may continue to accrue interest until you’re eligible for a distribution to pay the loan back.
Single-Sum Death Benefit. If you pass away before beginning your income stream, your beneficiaries can receive a set amount of your account.