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What Is a Tax-Sheltered Annuity?

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tax sheltered annuity

When it comes to saving for your retirement, you may have different options depending on where you’re employed. One of those options could be a tax-sheltered annuity (TSA). Here we’ll answer what tax-sheltered annuities are, how they work and how they differ from other common retirement savings plans, like a 401(k). Here’s what you need to know about tax-sheltered annuities and whether they’ll work for you.

For more help, consider working with a financial advisor.

Annuity Definition

An annuity is an insurance product used to fund a retirement. You buy a policy from an insurance broker and pay a premium now in exchange for payments later, generally in retirement. Some annuities pay for a short period of time, and others pay until death. If you’re worried that you might outlive the savings you’ve built with your 401(k) or IRA won’t quite cover the cost of your lifestyle, an annuity might be a good idea.

There are several different types to choose from, and they generally fall into one of two categories: fixed and variable. A fixed annuity offers a guaranteed return of the principal you paid in, along with a minimum amount of interest. Certain fixed annuities may be indexed, which means your returns are linked to a specific market index.

Variable annuities guarantee your principal investment but not your returns. You have the opportunity to choose your investments, and the better they perform, the higher your returns will be. An immediate annuity starts paying off as soon as you make an initial investment. Deferred annuities, though, don’t pay off until later. If you are retired, an immediate annuity might make sense.

What Is a Tax-Sheltered Annuity?

A tax-sheltered annuity, or TSA, is a retirement savings plan offered to employees of public schools and some nonprofits. Not unlike a 401(k) plan, TSAs allow employees of 501(c)(3) organizations to save for retirement using tax-deferred money. The IRS still collects their piece, but they do it when you withdraw.

You may see a TSA referred to as a 403(b) plan. These terms are sometimes used interchangeably, as they are both pre-tax retirement plans for public school and nonprofit employees. However, along with annuities, 403(b) plans allow for investment in mutual funds.

How Do Tax-Sheltered Annuities Work?

tax sheltered annuity

tax shelter shouldn’t be confused with tax havens, which are places outside the U.S. where people use shell companies to store money to avoid taxes. Instead, tax shelters are legitimate places you can keep your money without having to immediately pay the IRS. Think of your home equity or pre-tax retirement funds.

A tax-sheltered annuity or TSA combines the benefits of a tax shelter with the guarantee of an annuity. Contributors can choose from a variety of annuity types, like fixed, variable and indexed annuities.

TSAs are only available to public school employees and employees of certain 501(c)(3) organizations, such as charities and nonprofits. In general, they are allowed to contribute up to $22,500 in 2023 (and $20,500 in 2022). This is subject to change due to the cost of living increases. Employers can also contribute to their employees’ TSAs. When including employer contributions, the maximum yearly contribution goes up to $66,000 for 2023 ($61,000 for 2022).

Withdrawing from a Tax-Sheltered Annuity

When it comes to withdrawing from a tax-sheltered annuity, there are some rules. First, when you withdraw, you’ll be taxed. At the federal level, your withdrawal is taxed at the federal income rate. Depending on what state you live in, it’ll also be taxed as income (in those states that have income tax) or could be fully or partially exempt. Nine states don’t tax income and 11 states don’t tax retirement income.

Like with 401(k)s, TSAs have requirements around when you can withdraw without incurring a penalty. You must be at least 59 1/2 years old to withdraw from a TSA, or else you’ll face a 10% penalty in most scenarios. Among those exceptions are if you’re rolling money from one TSA into another because you switched employers and if you die before you hit the distribution age.

What’s the Difference Between a TSA and a 401(k)?

Both TSAs and 401(k) are pre-tax retirement plans that you can get through employers. The difference is that 401(k)s are offered through private, for-profit companies, whereas TSAs are offered through public schools and charitable organizations. If you work for both types of organizations, you could have both a TSA and a 401(k). However, know that you’ll be limited on how much you can contribute to both of them.

The Bottom Line

tax sheltered annuity

Tax-sheltered annuities, also known as TSAs or 403(b)s, are retirement savings programs that offer pre-tax deferrals to public school and nonprofit employees. In many ways, they’re treated as an equivalent to a 401(k). You’ll need to wait until you’re 59 1/2 years old to start withdrawing from a TSA or risk a 10% penalty. And remember that, because you didn’t pay taxes when you put the money in, you’ll need to pay it when you pull it out.

Tips for Getting Retirement Ready

  • Use our retirement guide to take advantage of helpful tools you can use to make the most of your retirement savings. From maps of retirement-friendly states to helpful calculators, you can make your retirement and social security work for you.
  • Determine how much you’ll need to save to retire comfortably using our retirement calculator. If your employer offers contribution matching, take full advantage of that to maximize your savings.
  • Working with a financial advisor can be invaluable to strategize how to invest your savings for retirement. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/Delmaine Donson, ©iStock.com/gorodenkoff, ©iStock.com/ijeab

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