What Is a Tax-Sheltered Annuity Plan?
All annuities are tax-sheltered savings vehicles that are designed and issued by life insurance companies. But, a "tax-sheltered annuity" normally refers to a special annuity generally designed for teachers called a 401(b) plan. These plans allow employees to save money for retirement and are part of a comprehensive pension plan.
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Types
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There are two types of annuities that are used in tax-sheltered annuity plans. The first type is a fixed deferred annuity. The other type of annuity used is a variable annuity.
Significance
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The fixed annuity contract earns interest based on a fixed interest rate set by the company. The fixed interest rate is determined by the insurance company's general account. Money in the annuity is invested in bonds and bondlike products and yields a guaranteed rate of return for the life of the contract. Variable annuities invest in mutual funds. The mutual funds are not guaranteed to produce any specific interest rate but have a higher earning potential when compared to a fixed rate annuity.
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Benefits
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Money in a tax-sheltered annuity offers two benefits. First, contributions made to the annuity are pretax. This means that the contributions are deducted from the employee's gross income, which lowers the amount of income tax for that individual every year he makes his contribution. Second, the annuity cash values grow tax deferred. No income tax is due on any money inside the annuity.
Disadvantages
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Money in the annuity is taxed when it is withdrawn. Because it is part of a government-qualified plan, money in the annuity must be withdrawn after age 70 1/2. If it is not, then a penalty of 50 percent is assessed on the amount of money that should have been withdrawn but was not.
Considerations
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A tax-sheltered annuity can help you save money for your retirement, but these plans are long-term savings plans. These plans also do not have the same liquidity features (the ability to borrow from the plan) as 401k plans. If you think you might need savings for some other purpose, make sure you set up a short-term savings plan.
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