What Is a Tax-Sheltered Annuity?


An annuity is a type of investment that exchanges an upfront payment for annualized income for life. The income is usually taxable, but some annuities are designed to defer or altogether avoid taxes, making them an effective tax shelter. The most common tax-sheltered annuities revolve around the tax benefits accorded to retirement savings accounts.


Any annuity with funds that are directed to a tax-deferred retirement account is essentially tax sheltered. The Internal Revenue Service, however, created a specific tax-sheltered annuity in section 403(b) of the Internal Revenue Code, and the term most frequently applies to these exclusively. 403(b) annuities are available only to employees of qualifying tax-exempt charitable organizations, public schools, unaffiliated ministers or Indian tribal government.


The government likes to cut or eliminate taxes on behavior it deems productive and useful, and saving for retirement clearly falls in that category. For the individual, the purpose of a tax-sheltered annuity is to put money away for retirement as painlessly as possible and to avoid double taxation. Because the funds are taken pre-tax before the paycheck, individuals do not have to worry about budgeting and the temptation to spend the money, or that they will be taxed first on income and later on capital gains.


These federally recognized annuities are usually funded, like 401(k) plans, by monies withheld from an employee's paycheck. The IRS puts a cap on the maximum amount an employee can contribute to a tax-sheltered annuity, but, as with other kinds of deferred-income accounts, some include so-called "catch-up clauses" that allow older employees to exceed the restrictions in certain instances.


When money is allocated to a tax-sheltered annuity, it is not simply held in waiting for the individual's retirement. As with other retirement accounts, the annuitant has choices as to how those funds can be invested, and several general types dominate the landscape. Some annuities operate like fixed income or bank CDs, earning a small but steady rate over time. Others can have adjustable rate returns or be indexed to the stock market.


One key to successful retirement planning is to provide for income from multiple sources. Not only does this likely increase the standard of living in retirement, it also provides diversity and lowers risk of loss prior to reaching retirement age. When organizing a tax-sheltered annuity, an individual should consider her entire financial situation and how the options available through the annuity increase the flexibility of her overall portfolio.

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