Definition
A Tax-Sheltered Annuity (TSA), also known as a 403(b) plan, is a retirement plan offered by certain non-profit and public education organizations. It allows employees to make pre-tax contributions to their retirement savings, thereby reducing their current income tax liability. The contributions and any earnings from the annuity are not taxed until they are withdrawn, generally during retirement.
Key Takeaways
- Tax-Sheltered Annuity (TSA) is a type of retirement plan often available to employees of non-profit organizations, public education entities, and self-employed ministers. They are desirable due to their contribution, growth and withdrawal tax benefits.
- TSA, also known as 403(b) plans, allow pre-tax contributions which lowers the taxable income for the year the contributions are made. The contributed funds then grow tax-deferred until withdrawal, typically in retirement.
- Withdrawals from TSA are taxed as regular income when taken out in retirement. If withdrawals are made before 59 ½ years of age, they may be subject to an additional 10% tax penalty, although there are some exceptions.
Importance
A Tax-Sheltered Annuity (TSA), also known as a 403(b) plan, is a retirement plan offered by certain public schools and other tax-exempt organizations that offers significant tax advantages for the employees. It’s an essential financial term because it allows employees to make pre-tax contributions, reducing their current taxable income.
The IRS doesn’t tax the contributions and earnings from these plans until the funds are withdrawn, typically at retirement. This tax-deferred growth potentially allows the investment to grow larger over time compared to a taxable investment.
Moreover, individuals may also be able to take a tax credit for the contributions. Hence, TSAs are important for financially planning for retirement and minimizing tax liability.
Explanation
A Tax-Sheltered Annuity, or TSA, serves a fundamental purpose of providing individuals, particularly those in certain sectors like education and non-profit organizations, with a long-term, tax-advantaged option to save for their retirement. It’s a type of retirement plan that allows employees to contribute a portion of their income into a special account that is purposely set to grow tax-free until the funds are withdrawn upon retirement.
This means that they do not pay income taxes on their contributions when those earnings are made, but they’ll be taxed upon withdrawal. Moreover, the use of Tax-Sheltered Annuity extends to an income deferral mechanism that lets the investments grow without incurring tax liabilities on the returns (including interest, dividends, and capital gains) until the time of distribution.
This can result in a potentially larger accumulation over time compared to a taxable investment account, where annual taxes could reduce the amount of money available for compounding. So essentially, a Tax-Sheltered Annuity operates as a means to both encourage and assist in retirement savings while providing beneficial tax treatment.
Examples of Tax-Sheltered Annuity
403(b) Plan: This is a common example, often used by public school employees, non-profit organizations, and certain ministers. The money invested in a 403(b) plan isn’t taxed until it’s withdrawn, typically after retirement. This allows the investment to grow tax-free over time.
457 Plan: This plan is designed for government employees, including state and local workers and some non-profit employees. Like the 403(b), funds invested are not subjected to income tax until withdrawn.
Individual Retirement Account (IRA): Certain types of IRAs such as Traditional IRA and Roth IRA offer tax-sheltered growth. In case of Traditional IRA, contributions may be tax-deductible and the growth is tax-deferred, meaning you’ll pay taxes upon withdrawal. In Roth IRAs, contributions are made with after-tax dollars but all the future withdrawals are tax-free in retirement.
Tax-Sheltered Annuity FAQs
What is a Tax-Sheltered Annuity?
A Tax-Sheltered Annuity (TSA) or 403(b) plan is a type of retirement savings plan for employees of tax-exempt organizations, certain ministers, and public school employees. The plan allows employees to save and invest money for retirement with significant tax advantages.
Who can contribute to a Tax-Sheltered Annuity?
Only an employer is allowed to contribute to a 403(b) account. The contributions are made on a pre-tax basis, which means the contributions and any earnings on them are not taxed until they’re distributed from the plan.
Are there limits to how much one can contribute to a Tax-Sheltered Annuity?
Yes, the IRS limits the amount of money that an individual can contribute to a 403(b) plan each year. For 2021, the maximum contribution limit is $19,500. However, individuals aged 50 and older may be eligible to make additional catch-up contributions.
When can I withdraw from a Tax-Sheltered Annuity?
Funds in a 403(b) account can be withdrawn without penalty after reaching the age of 59½. However, like with other types of retirement plans, early withdrawal before reaching that age may be subject to a 10% penalty.
What are the tax benefits of a Tax-Sheltered Annuity?
The primary tax benefit of a 403(b) plan is that it allows individuals to invest pre-tax dollars. This means that the money saved in a 403(b) plan reduces a person’s taxable income for that year, potentially moving them into a lower tax bracket. Also, any dividends or capital gains earned on the investments are not taxed until they are withdrawn in retirement.
Related Entrepreneurship Terms
- Deferred Compensation
- Qualified Retirement Plan
- Income Tax Reduction
- Salary Deferral Contribution
- Retirement Funds Withdrawal Allowance
Sources for More Information
- Internal Revenue Service (IRS): The IRS provides comprehensive information on Tax-Sheltered Annuity (403b) plans, including guidelines on who can set one up, contribution limits, and withdrawal rules.
- Investopedia: An international finance website that offers a deep dive into various financial and investment topics including Tax-Sheltered Annuity.
- The Motley Fool: This site offers articles, blogs, and tools about investing, stock ideas, and personal finance, including information about Tax-Sheltered Annuities.
- Charles Schwab: On their site, you can find a range of financial and investment information including Tax-Sheltered Annuities.
