What is a Tax-Sheltered Annuity?

What are the advantages of participating in a TSA?

Why should I participate in a TSA?

How much may I contribute to my TSA?

What forms of investment options are available?

What are the contribution limits for IRAs?

What are two-tier annuities?

When may I withdraw the money in my TSA?

What is the purpose of a withdrawal charge?

May I borrow against the money in my TSA for emergencies?

If I think I can receive a higher rate of return from another company, can I transfer my money?

What is meant by "old money" and "new money" rates of return?

What is the best way to withdraw the money from my TSA at retirement?

How should I go about selecting a Representative?

How is the representative compensated?

What is a Tax -Sheltered Annuity?

A Tax-Sheltered Annuity (TSA) or 403(b) plan, is named after a section of the Internal Revenue Code.  It is an employer sponsored retirement savings program. Participation is limited by law to employees of public educational organizations and certain nonprofit organizations. The vast majority of participants are employees in public schools, colleges, and universities. Contributions to a TSA are made for the participating employees by his or her employer. The money that is contributed to the TSA comes either from employer contributions-which are called non-elective deferrals, or from employee contributions, called elective deferrals. Elective deferrals are deducted from the participant's paycheck and forwarded to the insurance company or mutual fund custodian selected by the participant. The participant signs a salary reduction agreement, giving the employer the authority to make the paycheck deduction and remit it to the company chosen. Most TSA contributions are elective deferrals, meaning that the participating employee supplies the money to make the contributions.

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What are the advantages of participating in a TSA?

As the name Tax-Sheltered Annuity implies, contributions made on your behalf are not currently federally taxed, with the income tax deferred until the funds are withdrawn, typically at retirement. To illustrate the tax advantage of a 403(b) plan, suppose you are a teacher earning $35,000 this year. If you elect to put $5,000 in a TSA through a salary reduction agreement, you will pay current federal income tax on only $30,000, with the tax on the $5,000 contribution deferred until you withdraw the money. Both your contributions and the earnings are tax deferred until withdrawn, compounding the powerful tax advantage of a TSA.

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Why should I participate in a TSA?

While most state teacher retirement plans provide liberal retirement benefits, chances are your teacher retirement plan or other employer sponsored retirement program will not provide enough income after retirement to enable you to maintain your standard of living. A TSA permits you to supplement teacher retirement plans or another retirement plan.

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How much may I contribute to my TSA?

In some cases, if you have fifteen (15) or more years worked with the same district, you can contribute an additional $3,000 a year for 5 years for a total of $19,000.

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What forms of investment options are available?

The law permits TSA contributions to be placed in a fixed dollar annuity, a variable annuity, or a 403(b)(7) custodial account. Fixed and variable annuities are offered by life insurance companies, while 403(b)(7) custodial accounts are sponsored by mutual fund organizations.

The fixed-dollar annuity is one of the safest and simplest of the three choices. The insurance company receives the contributions on your behalf, invests them, usually in bonds and mortgages, and credits you with interest on your money.  The company must absorb any investment losses, and may not pass them directly along to your account. What you receive, purely and simply, is interest on your money, and in that respect, a fixed dollar annuity is similar to a savings account at a bank, although not FDIC insured. It is, however, a tax-favored savings account.

A variable annuity is more complex than a fixed-dollar annuity. Variable annuities offer a choice of investment alternatives, called sub accounts, ranging from a fixed account to growth stock funds, income stock funds, bond funds and so on. With a variable annuity, you accept the investment risks, while with a fixed annuity, that risk is borne by the insurance company.  However, if you are in a variable annuity growth stock fund, for example, and the stock market goes up sharply, you stand to earn far more than you would that year in a fixed dollar annuity. On the other hand, if stocks go down, you take the loss. There are additional costs related to a variable annuity.  Please ask your representative to explain these charges and their related benefits and risks.

A 403(b)(7) custodial account is a mutual fund selected by you from a range of choices offered by your employer.  There are many, many mutual funds from which to select, ranging from very conservative, low-yielding money market accounts, to high risk small company growth stock funds, to junk bond funds, anything you might be interested in investing in is probably available.  Naturally, you accept all investment losses and you get to keep any gains.

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What are two-tier annuities?

Two-tier annuities (sometimes also referred to as single tier or modified single tier annuities) have permanent withdrawal charges that increase the longer you keep the annuity. In contrast, a conventional annuity will have a withdrawal charge that declines to zero over a period of several years. In other words, the withdrawal charge on a conventional annuity declines to zero, and you may at any time thereafter, withdraw or transfer all of your money without any penalty.

Two-tier annuities typically offer higher current rates of return initially than you will find on conventional annuities. Actually, two different current rates of return are in effect; a higher, deceptively attractive rate on the accumulation value, and a much lower rate on the withdrawal value. The accumulation value is 100% of the contributions you make to the annuity, plus interest.  The withdrawal value is a fraction of your contributions (for example, 80% of first year contributions and 100% of renewal contributions) earning a lower rate of interest. A typical accumulation value rate of return might earn 5.5%, while the withdrawal value might only earn 4.25% or less.

Proponents of two-tier annuities argue that more money can be accumulated in a two-tier annuity, since a higher rate of interest is credited.  What they don't tell you, is that since you have to annuitize your contract to get the accumulation value, the insurance company is in a position during the payout period to, in effect, take back the higher interest initially credited to the accumulation value. The company does this by sharply reducing the credited rate of return during the payout period.

In contrast, if you purchase a conventional annuity, at some point in the future, there will be no withdrawal charge. At that time, or at any time thereafter, you may cash out your annuity with no withdrawal penalty (however, if you withdraw before you are age 59 1/2, you must pay a 10% IRS penalty).  Rates of return on annuity payouts options are usually poor, especially on shorter payout periods, such as three years or five years, where rates of return have commonly been only 1.75% to 2.5%.

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When may I withdraw the money in my TSA?

RMD (Required minimum distribution)

Under the general rules, you may begin withdrawals at any time once you have attained age 59 1/2, and you are required by law to begin making withdrawals once you are age 70 1/2. If you are currently working, you can extend your RMD to age 75.

If you separate from service with your employer prior to age 59 1/2, but after age 55, the law permits you to withdraw money from your TSA with no tax penalties or restrictions. Stretching out the distribution would systematically liquidate your account over your life expectancy.

If you die before you begin making any withdrawals from your TSA, your surviving spouse (if any) may become successor owner of your TSA, with the same rights as you had, except that a surviving spouse may not make further contributions. If your beneficiary is someone other than your spouse, he or she may take all the money at once or may stretch out the distribution over a period of years. The distribution rules are complicated, and it is important to comply with them to avoid tax penalties. We can provide you the information to assist you; however, you should consult a tax advisor prior to selecting a method of distribution. 

There is a reason for the withdrawal restrictions on your TSA.  When Congress enacted the law creating 403(b) plans, it intended for you to use your TSA as a retirement savings vehicle, not as a short-term tax-sheltered savings account.

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What is the purpose of a withdrawal charge?

Most fixed dollar and variable annuity contracts contain a temporary withdrawal charge.  The withdrawal charge is a penalty which is assessed upon early withdrawal of the funds in the account. In most cases, the withdrawal charge grades down to zero over a period of years, but watch out for annuities with permanent withdrawal charges (see two-tier annuities).

The withdrawal charge serves several purposes. On a fixed-dollar annuity, the insurance company must absorb any investment losses. Having a withdrawal charge permits the insurance company to invest in longer maturity investments with higher yields, and these higher yields are reflected in the current rate of return credited to your account. If there was no withdrawal charge, the insurance company could probably not afford to invest long-term, and shorter-term investments would mean lower interests rates on your annuity. The expenses associated with issuing your annuity are higher initially than in later years. The withdrawal charge allows the company a period of time in which to recover its initial costs through the spread, described earlier.

Mutual Funds might also have a withdrawal charge, known as a CDSC (Contingent Deferred Sales Charge). Normally, they start at 7% the first year and gradually go to zero after six years.  Mutual fund companies all have a different CDSC, and the investor should carefully read the prospectus to ensure they understand all the withdrawal charges before investing or sending money.

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May I borrow against the money in my TSA for emergencies?

Yes. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) made it possible for you to borrow from your TSA. Most fixed dollar TSA contracts have a loan feature, as do some variable annuities and mutual funds.  Loan provisions vary from company to company. The law permits you to borrow 100% of the withdrawal value of your TSA, so long as the loan does not exceed $10,000.  If the amount borrowed is to exceed $10,000, the maximum loan is the larger of  50% of the withdrawal value of your TSA or $50,000. Some companies allow you to use your Teacher Retirement System (TRS) statement in computing your loan value, this would allow you to borrow more from your TSA.

Example:

The loan must be repaid in at least quarterly installments of principal and interest over a period not to exceed five years. There is one exception: If the purpose of the loan is to acquire a dwelling intended to be your principal residence within a reasonable time, the repayment period may be extended beyond five years with the agreement of the TSA company.

When making a loan, first check to see what rate of return the company will charge you on the borrowed amount. Then, find out what rate of return will be credited on the funds in your account set aside as collateral for the loan.  You should take these things into consideration in deciding whether a TEFRA loan is better in your circumstances than borrowing from a bank or credit union.

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If I think I can receive a higher rate of return from another company, can I transfer my money?

Yes. IRS Revenue Ruling 90-24 permits partial or full transfers of TSA funds between fixed dollar annuities, variable annuities and 403(b)(7) custodial accounts.   There are some restrictions and rules, so consult your representative before making such a transfer.  The general rule is that all transfers must be conducted directly between the companies at your direction. Under this procedure, you may not have the check made payable to you and then endorse the check over to the new company.

In addition to tax free TSA transfers, you are eligible to conduct a rollover upon certain circumstances, including death, disability, separation from service with your employer or attainment of age 59 1/2. You may roll over a full distribution of your TSA funds into another TSA or into an IRA, within 60 days, tax free.  Rollovers of partial distributions are permitted under certain circumstances.

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What is meant by "old money" and "new money" rates of return?

The insurance company sets an initial rate of return which is credited to new premiums as they are received.  This is called the current rate of return on new money.  As premiums are received and invested, the company may place them in investment pools, and the rate of return on these pools is carefully monitored: When each contribution has been on deposit with the company for a period of time, the current rate of return is reviewed with reference to the earnings on the investment pool matched to that contribution.  The company may then make an interest adjustment to bring the rate of return in line with the spread formula. For reputable companies, these adjustments are small, and are merely pricing adjustments required to maintain the target spread.

Watch out for sharply lower old money rates. Some companies entice you to choose their TSA by offering especially attractive initial rates of return, then sharply cut the old money rate.  You may never know this, unless you ask.  If the initial new money rate seems especially high when compared to other companies, be skeptical, for chances are, the company is trying to hook you with an appealing initial rate, then will reel you in later with a much lower old money rate.

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What is the best way to withdraw the money from my TSA at retirement?

All the attention is focused initially (and rightly so) on setting up your TSA and selecting some of the best products suited for your circumstances.  But the attention should also be given to the vital question of planning distributions from the TSA after retirement.

All TSA annuity contracts, whether fixed-dollar or variable, contain annuity pay out options.  Pay out options, sometimes called settlement options, are different methods of systematically withdrawing the money in your TSA. A typical set of pay out options will include life only, life with period certain, joint and survivor, installment refund and period certain only annuity pay outs.  All of these options are designed to liquidate the principal and interest in your account over a period of time that complies with IRS regulations for TSA distributions. In competition, companies often compare their annuity pay out rates for life and ten year certain annuities for participates at age 65. That is an accepted benchmark for comparison within the industry.  However, experience shows that most TSA participants prefer to take their money out in other ways. 

Indeed, nothing in the IRS Code or Regulations requires election of a contractual annuity pay out option.  The IRS does require you to systematically withdraw the money in your TSA, once you reach a certain age.  This is called the Required Minimum Distribution (RMD) and is usually age 70 1/2, but not always (see "When may I withdraw the money in my TSA?").  Once you reach the RMD date, each year, you must withdraw a minimum amount in order to avoid a stiff  50% tax penalty imposed by the IRS.

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How should I go about selecting a Representative?

Choosing the right representative is very important. You need to be comfortable with your representative and his or her recommendations, and you need to feel you can work with that representative for a number of years.  The recommendations made by your representatives can mean the difference between a comfortable retirement and the less pleasant alternative.

Use common sense in choosing your representative.  A good rep will gladly answer questions and furnish references, and will not “high pressure” you.  High pressure sales tactics are inappropriate for an enrollment in a financial product.  What you need is information, and the best representatives either have the information you need at their fingertips, or will quickly obtain it for you.

Make sure they are fully securities registered and insurance licensed to sell all products and that they are not a captive agent for an insurance company. In the case of the latter, you will be limited to that company's products. When you are mapping out your future you want as few limitations as possible.

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How is the representative compensated?

Your TSA representative is paid by the insurance or mutual fund company for each product sold. Quite often, first year compensation is higher than in subsequent years, which recognizes the representative's greater investment of time during the initial sale and, for insurance products, delivery of the annuity.

Renewal compensation is usually paid to compensate the representative for the annual service work that is required (making changes, giving recommendations, and answering questions). Keep in mind that amounts paid to the representative are financed primarily from the company's spread, described earlier. 

There may also be a sales charge or front end load assessed on each contribution.  The representative must provide you a prospectus for all mutual funds and variable annuities he/she recommends.  They should review with you all risks, fees, and expenses so that you can make an informed investment decision. Please consult your tax advisor regarding your specific situation before you invest or send money.

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