Benefits Of An Annuity-Based Tax Shelter Plan
You divert a portion of your wages into the annuity and, when you retire, you can opt to receive a fixed monthly annuity payment for the rest of your life, or in some cases a lump sum. You can also choose to roll over the balance into a new investment scheme.
An annuity reduces the amount of income tax you need to pay for the year because it uses money deducted from earnings. Thus, if you make $20,000 a year and put ten percent of that ($2,000) into an annuity, then you only need to pay tax on $18,000 worth of earnings. This reduction in apparent earnings can also cause you to be classified in a lower tax bracket, so you pay even less taxes. Another attractive feature is that annuity payments are not subject to tax until they are withdrawn – thus the 'tax shelter' portion of the name.
Another advantage that an annuity offers is that the recipient can receive periodic payments no matter how much was in their account when they retired. Taxes are not levied at the time investments are made, although they are applied when funds are withdrawn from the annuity. However, since it is assumed that in 403(b) plans the individual will be of retirement age when he or she will withdraw funds (59.5 years old or older), it's most probable that the annuity holder will be earning less at the time of retirement and thus will be in a lower tax bracket. This means the taxes that need to be paid on funds withdrawal are also less.
Still another feature which may be attractive to some people is the fact that payments are elective and can be stopped and restarted with the negotiation of a new salary reduction agreement and other necessary documentation. In general, up to the lesser of $40,000 or 100 percent of eligible compensation can be contributed annually. Many employers also try to match their employees' contributions with their own deposits into the employee's annuity account, to avail of employer benefits come tax filing time and because the IRS mandates that they be 'fair and consistent' when making matching contributions.
Another upside is that in most annuities the policy holder has a large amount of freedom in choosing they want and investing in them. Under a tax shelter annuity plan, they can select investments they find interesting and competitive. They can trade or switch investments, or take advantage of the different investment options offered within a plan.
Drawbacks to Tax Shelter Annuities
First, since the 403(b) was designed to encourage people to save until retirement, it can be quite a hassle to withdraw funds. Secondly, if a person chooses early withdrawal of funds, for whatever reason, then penalties and surrender fees can be charged and the person will be taxed. Because annuities are for set terms, it is also impossible during the term to transfer the funds to another investment scheme without paying significant surrender fees. Annuity-based tax shelter plans also tend to have larger administration fees than other types of retirement plans. Employees should understand how their company's investment plan works.
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