Tax-sheltered annuity: Overview, definition, and example
What is a tax-sheltered annuity?
A tax-sheltered annuity (TSA) is a type of retirement savings plan that allows individuals to make tax-deferred contributions toward their retirement. These annuities are typically offered by employers, particularly in the public sector, such as for employees of schools, universities, and government agencies. The contributions made to a TSA are not taxed at the time they are deposited, but instead, taxes are deferred until the money is withdrawn, usually during retirement.
Tax-sheltered annuities come in various forms, including fixed and variable annuities, and they are designed to provide a steady stream of income during retirement. The primary benefit of a TSA is the tax deferral on contributions and earnings, which allows the investment to grow without being taxed until retirement when the individual may be in a lower tax bracket.
Why is a tax-sheltered annuity important?
A tax-sheltered annuity is important because it provides an effective way to save for retirement with immediate tax benefits. By deferring taxes on both contributions and earnings, individuals can grow their retirement savings faster compared to regular taxable accounts. This type of annuity encourages long-term saving by reducing the tax burden during the accumulation phase, which can result in a larger retirement nest egg.
For employers, offering a TSA can be an attractive benefit that helps attract and retain employees, particularly in sectors like education or government where retirement benefits are highly valued.
Understanding tax-sheltered annuities through an example
Imagine an employee, Jane, who works for a public school district. Jane is eligible to participate in the district’s TSA program, which allows her to contribute a portion of her salary to a tax-sheltered annuity. Jane decides to contribute $5,000 annually to the TSA, and the funds are invested in a portfolio of mutual funds.
Since the contributions are made on a pre-tax basis, Jane’s taxable income is reduced by $5,000 each year, which lowers her tax liability for the year. The investments in the TSA grow tax-deferred, meaning Jane does not pay taxes on the interest, dividends, or capital gains until she withdraws the funds in retirement.
When Jane reaches retirement age and begins withdrawing from the TSA, the withdrawals will be taxed as ordinary income. However, by that time, Jane may be in a lower tax bracket, resulting in less tax paid on the withdrawals compared to if she had been taxed on the contributions and earnings while they were growing.
Example of a tax-sheltered annuity clause in an employee benefits plan
Here’s how a tax-sheltered annuity clause might appear in an employee benefits or retirement plan document:
“Eligible employees may participate in the Tax-Sheltered Annuity (TSA) program, which allows them to make voluntary contributions to a retirement account on a tax-deferred basis. Contributions to the TSA will be deducted from the employee's pre-tax income and will be invested in the employee's selected investment options. Taxes will be deferred on both the contributions and earnings until the employee begins to withdraw funds from the account during retirement.”
Conclusion
A tax-sheltered annuity is a valuable retirement savings tool that allows individuals to defer taxes on their contributions and earnings, helping to build a larger retirement fund over time. These annuities are commonly offered by employers in the public sector and can be a critical component of an employee’s overall retirement planning strategy.
For employees, participating in a TSA can reduce their current tax burden while providing a tax-deferred way to accumulate savings for retirement. Understanding how a TSA works is important for maximizing its benefits and ensuring a secure financial future in retirement.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.