A tax-sheltered annuity, or TSA, is a long-term retirement planning strategy that provides a systematic, tax-sheltered approach to accumulate money for your retirement.  If an individual is working at a school or some other qualifying organization covered according to IRC Section 501(c) (3), they’re permitted to build-up funds for their retirement in a special tax-sheltered plan called a 403(b).  A TSA reduces the account holder’s actual taxable income.

The financial contributions in a TSA are omitted from an investor’s current taxable earnings and the interest or capital gains that are credited to the TSA are tax deferred up to the point in time that the TSA account holder begins to take distributions. The IRS has created a formula called the Maximum Exclusion Allowance that regulates the maximum contribution that a TSA account holder can make to the account in any given year.

Financial Security

A TSA delivers an enhanced level of financial security for the TSA account holder.  TSA’s are commonly offered as fixed annuities or equity index annuities.  These types of TSA’s are guaranteed in full to earn no less than a guaranteed minimum interest rate expressed in the annuity contract.  The fixed annuities are secured by the general account of the insurance carrier that has issued the annuity contract.

Moreover, owning a TSA will not impact any other retirement benefits. The TSA account holder can also obtain TSA benefits on top of their pension benefits.  Social Security credits are not affected because they are computed by the account holder’s gross earnings prior to any contributions to the TSA.

Impact on Taxes

A Tax Sheltered Annuity will reduce a TSA account holder’s personal income taxes. For instance, if an individual earning $40,000 a year and invests $4,800 into a TSA, that individual would only be taxed on $35,200. At a tax rate of 28 %, the TSA account holder would pay about $1,344 less in personal income taxes.  If you add the tax savings to the TSA contributions, the individual would accumulate even more money in their TSA and they would reduce their taxable income again.  At a 28% income tax rate, this would allow the account holder to contribute $555.56 a month with the same take-home pay as you’d have saving $400 a month with an account that is taxable.

For example, over a period of ten years, the Tax Sheltered Annuity advantage over a taxable account would amount to almost $31,000, assuming a 6.0% rate of interest for both accounts without withdrawals. Over twenty years the advantage would be more than $101,000. It’s apparent that a TSA allows an account holder to invest more money for retirement.

The IRS Rules and Regulations

Typically, the IRS will implement changes to most investment products each year and for 2018 they made several changes that will affect TSA account holders:

• The adjusted gross income (AGI) limitations have increased to $63,000 (up $1,000) for those who are filing as married filing jointly. For head-of-household filers, the new limit is $47,250 (up $750) and increased to $31,500 (up $500) for single, married filing separately, or qualifying widow(er) with dependent child filers.
• The limit for elective deferrals was increased by $500 to $18,500. The elective deferral represents the amount contributed to your plan by your employer which is excluded from your gross income.
• The new limit for contributions in 2018 was increased from $54,000 to $55,000.

The Pros and Cons of the Tax-Sheltered Annuity (TSA)

Pros

• The contributions to a TSA plan are tax deductible. This happens because pre-tax dollars can are invested in the account. The bottom line is a decrease in taxable income that is equal to the amount contributed to the TSA account. The amount you can deduct is dependent on the maximum restrictions based on your annual income.
• While your money is retained in the TSA, you can increase the amount of money through directed investments. You will not pay taxes on the growth in the account until you withdraw money from the account. When that happens, you will be taxed at your current income tax rate. Preferably, your tax rate will be lower at this point since you have likely retired.
• Certain individuals may be eligible for a tax credit based on deferred income placed in a TSA account.

Cons

• You receive tax benefits from a TSA account only if you utilize the money for its planned purpose. Because of this rule, if you withdraw funds prior to the compulsory minimum retirement age the withdrawal will result in a penalty. The penalty is equal to the taxes owed at an income tax rate equal to your current income tax bracket plus a 10 percent penalty on the early withdrawal.
• If you contribute more than the maximum allowed to your TSA account, you may have to deal with penalties from the IRS. The annual maximum will limit the amount of personal savings you can deposit into a tax-deferred account.
• Once you reach the age of 70 1/2, you’ll be obligated to make withdrawals from your TSA at a specified amount. If you fail to meet your required minimum distributions, you will have to deal with excess contribution penalties.
• Eventually, when you invest money in an account that is eligible for a specific tax status, you are removing your freedom over the use of those funds. In order to receive the benefits the IRS is willing to provide, you must also follow the IRS’s rules on the account. Only set up a TSA if you are prepared to follow these guidelines because not following the rules will result in penalties.