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Tax-Sheltered Annuities 101

Annuity products can be very valuable tools in financing a retirement. While they don’t make sense for everyone, many can benefit from the guaranteed lifetime income payments provided by an annuity. Unfortunately, because some products are rather complex, there are many misconceptions, giving them a bad reputation. One of the best ways to overcome this issue is through financial education. Today, let’s look at one type of annuity, tax-sheltered annuities, and break down the basics (with information from Bankrate’s glossary).

What is a Tax-Sheltered Annuity?

If you are an employee of public schools or of certain tax-exempt organizations, there’s a good chance your benefits may include a 403(b) plan, also known as a tax-sheltered annuity (TSA). This retirement savings plan allows employees to invest pretax dollars to build income for retirement. Tax-sheltered annuities are meant to provide retirees with consistent payments over time, providing reliable income in retirement. Contributions are deducted from income before taxes are taken out. But while the investment grows without being taxed, they are eventually paid once the employee begins to receive payments from the investment.

How are annuities structured?

There are several ways in which an annuity can be structured. Some can provide income for a predetermined time period (i.e., 25 years), while others guarantee payments for the annuitant’s whole life. Some can even provide income to a surviving spouse after a policyholder passes away. In general, fixed annuities offer a regular payment for a specific time period, while payments from a variable annuity reflect market performance.

Where can I get an annuity?

There are many companies who market annuities, but only insurance companies can actually issue them. Banks, financial planners, investment advisors, estate officers and mutual fund companies can all market annuities, but they must carry an active life insurance license and a securities license. One of the heaviest criticisms of annuity products revolves around the commision earned on annuity sales for some financial professionals. Because brokers and planners typically earn a higher commission on them (compared to other products they sell), they may be biased towards them.

What are the advantages of owning an annuity?

The peace of mind from a guaranteed, consistent retirement income is often touted as the biggest advantage. Additionally, annuities are also protected from probate proceedings and from creditors typically.

What are the drawbacks?

Many consider the lack of liquidity to be the biggest drawback of annuities. Annuity contributions are usually subject to surrender periods, and a stiff penalty can be applied if withdrawals are made before it is over. Surrender periods can last more than 10 years and the penalty fee can be more than 10%. Because some annuities charge high fees, it’s critical to fully understand how much you’re paying before signing on the dotted line.

Are there contribution limits?

The same limits applied to 401(k) plans are also applied to TSAs. A catch-up provision for those over 50 years old is also in play. This means that participants who have worked for a qualifying organization for 15 years or more and averaged a contribution limit of $5,000 or less are eligible for lifetime catch-up.

When can withdrawals begin?

Annuity holders can begin taking withdrawals without penalties after age 59 ½,, but must begin withdrawing by age 70 ½. Some plans include provisions that allow employees to borrow money from the fund before 59 ½, or take early withdrawals if they become disabled. Withdrawals are taxed as ordinary income.

What’s the difference between TSA, 401(k), and 403(b)?

A TSA is a tax-deferred plan that provides long-term investment for retirement savings, just like a 401(k) plan. They are, however, only available to employees of tax-exempt organizations, unlike 401(k) plans, which are open to any private sector employee whose employer offers a plan.

The terms “tax-sheltered annuity” and “403(b) are often used interchangeably. The 403(b) was first created in 1958, and at that time it only offered annuities, but the plan has evolved over time. Many 403(b) plans still offer tax-sheltered annuities, they also offer investments seen in 401(k) plans, including mutual funds.

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