Tax Sheltered Annuities: A Complete Guide

For many retirees, a 401(k) is a solid retirement option that enables them to make contributions as they work and often gain certain tax benefits. However, for those working in nonprofits, public schools, and other tax-exempt entities, there is another option. A 403(b)–also known as a Tax Sheltered Annuity, or TSA plan. TSAs provide those in tax-exempt entities to put funds away toward their retirement with certain tax benefits. So, what exactly is a tax-sheltered annuity? Who is eligible for one–and how do they work? We’ll discuss this in more depth. Let’s dive in!

What is a Tax Sheltered Annuity?

A tax-sheltered annuity plan, 403(b), or TSA, is a retirement option for workers in certain tax-exempt organizations. With tax-sheltered annuity plans, employees are able to move some of their income into their 403(b). What’s more, this retirement plan offers certain tax benefits that can be, in some cases, potentially useful to those saving for retirement. For example, contributions made to a 403(b) are generally tax deferred until the money is distributed–and gains earned within a 403(b) account are usually not taxed currently either until you’re ready to pull your earnings out.

Not all 403(b) plans look the same, however. For one thing, some 403(b) plans might also offer a designated Roth account. While, typically, contributions that employers make into a 403(b) as well as gains within the account are not taxed until distribution, money that’s put into a designated Roth is subject to tax. Conversely, distributions from a designated Roth account are not taxed. So, while with a typical TSA, you might not be subject to taxes the year you contribute or for earnings in a TSA, with a designated Roth account, you might be taxed on contributions, but not when you get ready to pull your money out.

In any case, you might be penalized for withdrawing money early. If you’re under the age of 59 and a half, making a withdrawal can potentially cost you a 10% penalty.

Who is eligible for TSA?

Many employees of tax-exempt organizations are eligible for a 403(b) account. This might include employees at educational institutions such as public schools, at churches, and at other tax-exempt organizations such as nonprofit organizations. If your organization is eligible to sponsor a 403(b) program, and you’re an employee, you might be able to get a 403(b).

Employees who may be excluded

Even if your organization is eligible to sponsor a 403(b) program, there are some criteria that employers may be able to use to exclude certain employees. These might include employees who work less than 20 hours a week, employees who will not contribute at least $200 annually, employees participating in other retirement programs such a 401(k) or different 403(b), and more.

How do TSAs work?

TSAs work much like a 401(k) account might in some ways; for instance, employers can divert a part of their income into the account. Much like a 401(k), investments might be limited to those chosen by an employer, and alsomuch like a 401(k), employers may choose to match contributions or offer a salary reduction agreement. As contributions to and earnings within a typical TSA are tax-deferred, early contributions can be highly advantageous. However, early withdrawals can be expensive as they may incur a 10% penalty.

Contribution limits

The amount that employees and employers can contribute to their 403(b) might be constrained by annual contribution limits. The IRSexplainsthat there are annual limits on not only employee elective deferrals but on total annual additions as well–which might include contributions made by both the employer and employee. In 2022, the limit on total annual additions was $66,000, for example. Meanwhile, the limit on employee elective deferrals for the same year was $20,500.

Exceptions to contribution limits

There are a couple of so-called “catch-up” provisions which allow for exceeding the normal contribution limits.

One catch-up provision for participants is for employees of eligible organizations that offer a 403(b) program (one which allows for this) who have been with the organization for at least 15 years. The IRSexplainsthat employees such as this may be eligible to exceed their normal annual limit by:

“the lesser of $3,000, $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.”

Ultimately, one who is eligible for this provision might be able to make elective deferrals to the amount of $22,500 in 2021 and 2020. Normally, during those years, the elective deferral limit for employees would have been only $19,500.

A second provision has to do with how old an employee is. Employees over 50 years of age might be eligible for this second provision. This allows employees over 50 years of age by the end of the calendar year to which contributions are applicable to exceed their normal contribution limit by $7,500 in 2023. In previous years, this would’ve been lower–$6,500 between 2020 and 2022 and $6,000 between 2015 and 2019.

Other considerations – contributions

Since employees are able to have both a 403(b) and other types of qualified retirement plans simultaneously, they must ensure that their total contributions across all 401(k), 403(b), SIMPLE IRA, SIMPLE 401(k), and SARSEP accounts must not exceed annual limits. For example, if you have both a 401(k) and a 403(b) account, you may not be able to defer more than $22,500 for the year of 2023 between both accounts. So, while if you only have a 403(b) account, this may be of little concern, it’s important to note, and particularly important if you have multiple retirement plans.

Investments

Investments in TSA plans can take a few forms–but typically, they’ll be in either annuities or mutual funds. Differentannuitiesmight be more or less suitable for different participants. For example, those concerned about inflation might opt for a fixed index annuity. To some, this might seem more limited than other types of retirement plans, such as 401(k)s, where you might be able to invest in ETFs. Like many other employer-sponsored plans, your options may be somewhat limited and determined by your employer.

Withdrawals

Understanding when withdrawals can be made is an important part of understanding how tax-sheltered annuities work. While normally, employees might wait until they reach age 59 and a half years, there are certain situations where employees might opt to take money out sooner and a few instances where they’re able to.

Early distribution

In many cases, those with 403(b) accounts may need to wait until they’re at least 59 and a half years of age before they begin to pull money out, but there are a number of exceptions to this. For example, employees who have become disabled, have encountered financial hardship, have had a severance from employment, or who have died might be able to pull out their money before then. Regardless, if so, that employee might need to pay taxes for pre-tax contributions. They also might incur a 10% IRS penalty for withdrawing early. In some cases, though, that employee might be eligible to roll over their distributions into another account.

Required minimum distributions

While eligibility for early distributions might depend on a few factors, there will also be a point where you’re required to begin taking distributions each year. This might be determined by your age; starting in 2023, the age at which people must begin taking minimum distributions is 73 years old.

Understanding the internal revenue code can be useful when trying to understand required minimum distributions. Previously, this age has been lower, but the SECURE 2.0 act raised this age. Once you’ve reached the age at which you’re required to take minimum distributions, you may need to begin pulling money out in order to avoid penalties, though there are a few exceptions that you can find out more abouthere. The amount that you need to pull out can vary depending on many factors, including the amount in your retirement account, as well as life expectancy tables published by the IRS. In order to calculate your required minimum distributions, you can usethese worksheetspublished by the IRS.

The bottom line

Whether or not you choose to participate in your employer’s 403(b) program, understanding the ins and outs of a tax-sheltered annuity can be an important part of making an informed decision. Still, it’s never a bad idea to discuss what your investment or retirement plans are with a certified financial planner or legal counsel. While each type of retirement plan comes with its own unique characteristics that can be benefits or drawbacks depending on your particular situation, a tax-sheltered annuity can be a viable option for certain employees in certain tax-exempt organizations in certain situations.