What is a tax-sheltered annuity?

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Category: Individual Taxes

Written by Jonah Sparks

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Are you evaluating annuity options or trying to decipher annuity information? If so, chances are that you'll come across information about the tax-sheltered annuity. What is a tax-sheltered annuity and how does it compare with all of the other annuity options out there?

One of the reasons that tax-sheltered annuities are so attractive is that they allow you to defer your taxes. By contributing an established percentage of your income into an account designed for long-term savings, you are not required to pay taxes on those funds when you earn them. Instead, you are taxed when you withdraw the funds at a later date. The obvious benefit is that you can reduce your current tax liability by reducing your taxable income.

Unfortunately, not everyone can take advantage of this type of annuity. IRS code 403(b) specifies the types of employees that qualify for a tax-sheltered annuity. If you happen to work for a tax-exempt charitable organization, a public school, a self-employed minister or the government of an Indian tribe then you most likely qualify. Be aware that other types of annuities and investments may refer to themselves as tax-sheltered but unless you quality under 403(b), then you are not contributing to a genuine tax-sheltered annuity.

As with other annuities, tax-sheltered ones come with limits and there is a maximum annual contribution. Contributions in excess of that amount will be taxed based on your tax bracket but there are ways to soften the blow. Take advantage of catch-up clauses if they are available and look for employer-matched annuities.

Tax-sheltered annuities are excellent options when planning for retirement. Realize that your income during retirement will most likely be somewhat to significantly less than your income at the time of contribution. Therefore your annuity withdrawal will be taxed at a much lower rate than it would have been if you had claimed it during the year in which it was actually earned. The end result is savings both when you contribute the funds and when it’s time to withdraw them. Be aware that you may face penalties or fees if you chose to withdraw your funds prior to retiring.

If you're examining annuity options, a tax-sheltered one is a solid choice for a portion of your retirement portfolio. However, it should not be the only part of your plan. Like other annuity options, a tax-sheltered annuity is only as good as its guarantor. You should consider contributing up to the annual amount only and then distributing your retirement funds across other types of investments.

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