What is Tax-Sheltered Annuity?
Tax-Sheltered Annuity (TSA) is a form of retirement savings plan in which the contributions made are from the income that has not been taxed and therefore the contributions and interest accrued on the same are not taxed during the period of savings while only the withdrawals are taxed.
- As per the 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-exempt organizations and falls under the terminology of 403(b) plans
- The part of income that is contributed to this plan and the accumulated interest on the same, are excluded from the taxable income and only the remaining income is taxed. The benefit is not given to those employees who are a part of the Roth IRA plan. In which case, the withdrawals are not taxable. So basically, Roth IRA and TSA work in diametrically opposite ways and are means of when the employee wants to pay the tax.
- 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 receives similar benefits from 401(k) accounts.
How does Tax-Sheltered Annuity Work?
The setting up of 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 has been increased to USD 19,500 for the year 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 the employer and employee contribution.
- If an employee has more than one retirement savings plan, then the combined annual total contribution should be as 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:
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- Under Elective deferral, the employer deducts his contribution from the salary of the employee and direct deposits into the savings account. Roth contributions are taxable while withdrawals are not while it is the opposite for 403 (b) contribution.
- 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, which combine features of all of the above and are at times 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.
- If the contribution had been made under the effective deferral program, then the described financial hardship allows distribution.
These withdrawals are taxable entirely under the ordinary income 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 in which the employee reaches the age of 70 years and 6 months or when he retires, whichever falls on a later date. The interest amount can be transferred to another employee under contract exchange provision, and this transfer is tax-free. However, several conditions need to be met for such a transfer post-September 24, 2007.
- Instead of withdrawing, at the end of the TSA, accumulated funds can be rolled over to a Roth IRA as per the specified rules. Such rollover gets taxed in that year.
- 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 in paying lower taxes and having higher disposable income
- An employer also contributes to the fund, and at times it 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 even later time.
- At times when the employee faces financial hardships, and these fall under the described category, then the employee is able to withdraw the amount without paying a 10% penalty on premature withdrawal.
- Finally, as with all retirement plans, some amount of income is saved for the future, securing retirement needs.
- 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 penalty as per the describe rules of the account. Therefore the process of gathering proof that such a penalty doesn’t apply in certain cases becomes tedious and causes stress when there is an urgent need of funds.
- There are caps on the maximum amount that can be contributed in 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.
- In the end, the TSA is a form of deferring taxes to a later point of 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 accrued during the time of the account before the retirement is not taxed as well; 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 tax rules of the country applicable to the employee.
This has been a guide to What is Tax-Sheltered Annuity & its Definition. Here we discuss the tax-sheltered annuity 403(b) plan and how it works along with advantages and disadvantages. You can learn more about from the following articles –