How prepared are you for retirement? With people living longer thanks to modern medicine, saving up enough money for your golden years can seem frightening. In this article, you’ll learn about the Tax Sheltered Annuity & How are Annuities Taxed? Let’s dive in.
If you already have retirement accounts, that’s a step in the right direction. But, you must understand your tax responsibilities to prepare for and lower your tax bill when possible. Lets learn what are annuities and how Tax-Sheltered Annuities can be helpful in saving taxes.
What Are Annuities?
An annuity is a type of insurance and qualified retirement plan.
Financial institutions pay out invested funds in a fixed income stream in the future. Investors and individuals can invest in or purchase annuities with lump-sum or monthly premiums.
The holding institution will issue future payments for a specific period or the remainder of the annuitant’s life.
Annuities are most common for retirement purposes. They help lessen the risk of someone outliving their savings. Unfortunately, this is a common occurrence.
There are two phases of an annuity. The first is accumulation. This is the time when the annuity receives funding before payouts. The second phase is annuitization (distribution). This is when payments begin.
You can purchase immediate or deferred annuities. Immediate annuities are for those with a large sum of money to put into the annuity. It’s ideal for those who inherited money or won the lottery.
An immediate annuity allows you to exchange the lump sum for cash flows into the future.
A deferred annuity expands on a tax-deferred basis. It provides the account holder with a guaranteed income.
Annuities can also be fixed or variable. Fixed annuities provided regular payments.
Whereas variable annuities allow for larger future payments if the investment does well and smaller payments if the investment does poorly.
Variable annuities create more flexibility in handling market shifts.
What Is a Tax-Sheltered Annuity?
A tax-sheltered annuity (TSA) is a pension plan for employees of:
- Non-profit organizations and charities
- Public school systems
- The government
Participants can also include self-employed ministers and church employees, nurses, and doctors.
A common TSA is the 403(b) plan. A 403(b) plan allows holders to invest pre-tax funds in an annuity or custodial account.
Pre-tax means you don’t pay tax on the funds you contribute to the plan (at least not right away).
These plans are similar to 401(k) plans for-profit businesses offer their employees. Employers can make direct contributions to a TSA.
This is beneficial to employees because they have additional tax-free funds in the account.
The IRS sets tax code limits on how much employees can contribute to their 403(b) plan annually. The maximum contribution amount for the 2021 tax year was $19,500. In 2022, it’s $20,500.
Those aged 50 and over can add another $6,500 for 2021 and 2022 to catch up on contribution payments.
If you can, max out your contributions each year to take full advantage of the plan.
403(b) Annuity Payroll Deductions
Employees need to give their employer permission to reduce their salary to contribute to a 403(b). You can do this through a salary reduction agreement (SRA).
After signing an SRA, your employer will take the reduction and gives it to an insurance company to fund a 403(b) account.
The IRS doesn’t withhold federal income taxes on the salary that goes to the 403(b). Instead, the money is excluded from an employee’s gross income for federal and most state income tax purposes.
Further, the IRS withholds FICA taxes from the money you contribute to your 403(b). FICA taxes include Social Security and Medicare tax.
This means you will still contribute to your FICA taxes while saving money for retirement.
Are Annuities Taxable?
Annuities come with complex tax ramifications regardless of your type of annuities.
However, often they are tax-deferred. That means you don’t have to pay taxes right away, but eventually, you’ll need to pay.
You will pay taxes on an annuity once you start receiving income payments from the fund. The IRS taxes withdrawals and lump-sum distributions as ordinary income.
Beware: if you take a lump-sum distribution, it could place you in a higher income bracket. That would force you to pay a higher income tax percentage. You’ll want to work with a CPA or tax professional to identify your tax bracket.
Let’s look at annuity taxation more in-depth.
Qualified vs. Non-Qualified Annuities
When it comes to taxes, annuities fall into two categories: qualified and non-qualified.
A qualified annuity allows you to fund your account with pre-tax dollars. You will need to pay ordinary taxes on the distribution amount. However, you may have tax-free annuities if you purchased annuities with a Roth IRA or 401(k).
There are specific eligibility requirements for your annuities to be tax-free under these circumstances.
Further, if you invest in an annuity to fund a retirement plan or IRA, the annuity will not provide extra tax benefits for that plan.
Qualified annuities must follow the Required Minimum Distribution (RMD) requirements. This means you need to start taking distributions from the annuity by April 1 of the year after you turn 72.
A non-qualified annuity uses post-tax dollars. This means you only pay taxes on the earnings or interest amount of the distribution. So you don’t pay taxes on principle.
Post-tax means you’ve already reported the income to the IRS and paid taxes on it. So, you don’t have to pay taxes on it again.
Non-qualified annuities don’t need to follow RMD guidelines.
To figure out how much you need to pay on the earnings of a non-qualified annuity, the IRS uses the exclusion ratio.
This ratio includes:
- The principle you used to purchase the annuity
- The lifetime of the annuity
- Interest earnings
However, if the annuitant lives longer than their actuarial life expectancy, annuity payments after that age become entirely taxable.
The taxation discussed is when you withdraw funds according to the annuity terms.
Yet, annuities are illiquid. This means there is a surrender period where you cannot touch the money. The surrender period can range significantly in length. Sometimes it’s only a few years. Other times, it’s longer than ten years.
Early withdrawal before the age of 59 1/2 or during the surrender period will lead to a high tax penalty. This includes a 10% early withdrawal fine from the IRS.
An annuity issuer can also place extra charges on early withdrawals. So always consider the penalities before taking money out of your annuity.
When Early Withdrawal Is Valid
The requirements for when you can withdraw money from an annuity are strict. Yet, particular circumstances allow you to remove the money without facing penalties.
These are triggering events, such as:
- Employment termination
- Financial hardship from medical bills or college expenses
- Qualified domestic relations order (QDRO) from a divorce
- Return of excess elective deferrals
Working with a tax consultant will help you determine if you can withdraw from your annuity early.
Inherited Annuity Taxes
You need to follow the same tax rules if you inherit an annuity. In this case, you are the beneficiary of the annuity.
Any principle that was funded with pre-taxed money will remain untaxed. Any principle that wasn’t taxed previously will be subject to taxes.
The amount of previously taxed principle in each annuity income payment is excluded from federal income tax requirements. This is the exclusion amount.
Does a TSA or 403(b) Have Tax Advantages?
The most significant benefit of a tax-sheltered annuity is that it reduces your taxable income. Of course, this is assuming you have a pre-tax annuity. Remember, some annuities use post-tax dollars.
Your contributions are deductible in a pre-tax annuity like a 403(b). Reducing your taxable income means you could land in a lower income bracket. If this is the case, you will pay less in taxes to the IRS each year.
Plus, in retirement, your income is often lower than your working years. Thus, you would remain in a lower tax bracket during retirement even though you pay ordinary taxes on your distributions.
Conversely, you can choose a post-tax 403(b) if you anticipate growing your fund significantly before you retire. A Roth 403(b) is a great choice for those who foresee themselves having a higher income when they retire.
Paying taxes now could lead to a bigger retirement fund in the future. Working with a tax professional will help you decide which is best for you.
Another benefit briefly mentioned before is the ability of your employer to make contributions. Many employers have a match system to determine how much money they will contribute to your 403(b).
If you’re making regular contributions, you’re receiving free money from your employer for retirement. While you’ll pay some tax on the money in the future, it’s money you didn’t need to contribute to the plan.
Learn More About Taxes
Now you have a firm understanding of how Tax-Sheltered Annuity works and How Are Annuities Taxed? Continue reading more articles on our blog to learn more tips and strategies about saving taxes.
If you have a 403(b) plan, consider consulting with a CPA to learn more about making your retirement money grow with minimal tax responsibilities.
To read more about taxes, head over to our Taxes section. We add more content regularly so that our readers have the most up-to-date information.