Legal And Financial Questions: What Is An Annuity Tax Shelter?

Tax-sheltered annuities may be a good investment choice to save for your retirement while sheltering a portion of your income from taxation.

Investing in an annuity may offer you the opportunity to save for your retirement years while sheltering a substantial portion of your income from taxation.


Simply stated, an annuity is an investment vehicle which allows you to accumulate savings and to earn additional income toward your retirement. The annuity itself is similar to an insurance policy. Unlike other retirement investment vehicles, such as IRAs or 401(k) plans, your annuity will have a specific contract term, e.g., ten years. You purchase the annuity by making payments into it from your earnings during your working years. Then, when you retire, you may elect to receive a fixed monthly sum annuity payment for the remainder of your life. In some cases, you may elect to receive a lump sum payment or "roll over" your annuity balance into another investment vehicle.

The annuity provides a tax shelter because it is funded with pre-tax dollars. In other words, money is deducted from your earnings, before taxes are taken out, and then contributed directly to the annuity fund. You do not pay taxes on the money when it is earned. This may benefit you in a number of ways. Most significantly, it decreases the amount of money you are going to pay taxes on for the year. Additionally, it may drop you into a lower tax bracket, so that you pay less in taxes on your remaining earnings.


In previous years, many Americans depended solely on Social Security to fund their retirements. However, it has become increasingly apparent that Social Security funds alone will not be sufficient to support American workers in their retirement years. Social Security was a great idea in theory. Each American worker pays a certain percentage of his or her earnings into a fund that will go toward making monthly payments to workers who retire, workers who become permanently disabled, or the spouses and/or family members of workers who die. The problem with this concept is that the funds paid by each worker are not set aside for the retirement of that particular worker. Instead, funds being paid in by today's workers are being paid out to support yesterday's now-retired workers. With a huge population of baby boomers now approaching retirement, we are facing a situation where more funds are being paid out each year than are being contributed.

When the flaws in the Social Security program became apparent, the United States government began encouraging Americans to save more for their own retirements. This was no easy task. Americans are not a society of savers. In fact, Americans typically spend all of their earnings and then some, going further and further into debt each year. When it comes time to retire, most Americans have little or nothing set aside to carry them through their retirement years.

So, in recent years, the United States government has formulated plan after plan to encourage Americans to save for their retirements and to reward those who do. The government began offering tax breaks to Americans who save and invest toward their retirement. Annuities are among those government-sanctioned savings programs. Accordingly, an annuity is the best of both worlds. It is not only a saving device; it also ranks among the very best in tax shelters.


First, under the provisions of the Internal Revenue Code, the employee's contribution to an annuity is made before taxes. For example, if an individual is making $30,000 per year and contributes fifteen percent of his or her earnings to an annuity each year, then that fifteen percent or $4,500 comes off the top, leaving the employee with taxable earnings of only $25,500 for the year. The employee is taxed only on $25,500 in earnings, rather than $30,000 in earnings. The employee has successfully "sheltered" $4,500 in earnings from taxation. Additionally, employees will not have to pay taxes on the interest or earnings on their annuity accounts until withdrawal, so these earnings are also sheltered.

Unlike other government-sanctioned retirement plans, such as IRAs or 401(k) plans, annuities offer the option of receiving payments for life, no matter how much is in your account when you retire. Most annuities offer a death benefit, although this is usually quite limited. Many annuities also offer you the option to roll your account funds over into another investment vehicle rather than elect payments for life.

You may receive additional tax advantages when you retire and do withdraw funds from your annuity. Although you will not pay taxes on the money invested at the time it is invested, you will be required to pay taxes on it when it is withdrawn. However, in most cases, you will be making less money when you retire and will be in a lower tax bracket. Accordingly, you will pay taxes on the money at a lower rate.

There may also be other benefits to investing in an annuity. Unlike IRAs or 401(k) plans, there is generally no limit to the amount that you can invest in an annuity. Also, many employers make "matching" contributions toward their employees' annuity accounts. For example, your employer may offer to match your own contribution, up to say five percent. Some very generous employers may match your contributions dollar for dollar. Employers may also make additional contributions to their employees' accounts before filing their own tax returns, to receive the employer benefits of doing so. Under IRS rules, employers must be fair and consistent with matching contributions. In other words, in most cases, the system of matching contributions must affect all employees equally.

Another benefit of investing in an annuity is that the money may be available to you in the event of an emergency. Many annuity plans have provisions allowing early withdrawal of a portion of your funds under certain emergency circumstances. Some plans also allow employees to "borrow" against the funds in their account for things such as sending their children to college or purchasing a new home. However, be aware that penalties may be incurred for such withdrawals.

Most annuities also offer a great deal of freedom in switching investments within the plan. For example, you may buy and sell mutual fund shares within your plan without incurring taxes or penalties. This offers you much more control over your investment and is also a lot more fun, especially if you are a savvy investor or are interested in learning more about investing. There are many online and print periodicals and journals which you can use to research the different investment options available in your plan. You may then select the investments which appeal to you.


There are some disadvantages to investing in an annuity. First, employees should be familiar with the rules governing their company's particular investment plan and be prepared to abide by them. Keep in mind that the purpose of the annuity is to save for retirement. You may have very limited or no access to the funds in your annuity account prior to retirement. And, if you do withdraw the money before the specified retirement age, you will have to pay taxes and stiff penalties for early withdrawal.

This applies even if you are laid off from your job or change jobs. If you choose to "cash out" your annuity when you leave your employment, you will be taxed and will have to pay early withdrawal penalties and, perhaps, surrender charges. You will have to do this even if you are facing a period of unemployment. Be prepared to roll your annuity funds over into another tax-sheltered investment vehicle immediately in order to avoid these penalties.

Annuities also have certain characteristics that set them apart from IRAs and 401(k) plans. For example, because it is more like an insurance policy and offers the benefit of lifetime payments, an annuity is a contract and has a specified term. If you sign up for a 10-year annuity, then you will not be able to freely move the funds. You can't move them into another investment vehicle, outside the annuity, until the ten year contract term has been completed. If you do, you will be required to pay substantial surrender charges. Also, annuities typically have higher administration fees and charges than other retirement investment plans.

As a rule of thumb, if you are not certain that you will be able to invest the funds and then leave them untouched until retirement, you may want to consider other investment options. For example, the Roth IRA offers some of the tax shelter benefits of an annuity, regular IRA or 401(k) plan, but gives you much more access to your money. When you invest in a Roth IRA, you invest with after-tax dollars, so you do not receive the tax benefit of investing with pre-tax dollars. However, your money grows without being taxed. In other words, you are not taxed on the interest or earnings on your account until you withdraw the funds. And, generally, you can withdraw the principal (the amount you contributed and on which taxes have already been paid) without penalty or further taxation.


Your annuity payments generally go into a mutual fund or similar investment vehicle. Depending on the annuity plan and company, as well as the employer's own rules, the employee may have varying degrees of control over how the contributions are invested. In the very best of plans, employees will be permitted to choose their own investments and shift between investments as their investment goals change. They may choose to have the contributions invested in very safe and steady investments, such as bond mutual funds, or more risky investments with the possibility of higher rates of return, such as mutual funds with a high stock ratio. Many people choose to invest in mutual funds which offer a mix of investment vehicles designed to offer a higher rate of return while tempering the amount of risk to the investor. Again, the mix of investment tools used in the mutual fund varies. An investor may choose a fund with a very low or a very high rate of risk or, alternatively, something in between.


If you are buying into an annuity plan through an employer, then your employer will select the annuity. Depending on your employer's annuity plan, you may have a good deal of control over how your money is invested. You will also have control over the level of your investment, i.e., how much money you will invest each pay period. Generally speaking, if you are offered an annuity plan through your employer, you should opt in at the highest level permissible. This is particularly true if your employer offers matching contributions. Not only will you receive the tax advantages of your own contributions, you will essentially receive additional free money from your employer which will also grow tax-free. Most employer plans will have a vesting schedule in place, so you will probably be required to work for the employer for a certain period of time, e.g., seven years, before you are fully vested in the employer's contributions.

If you are looking into purchasing an annuity on your own, seek the advice of a trusted financial counselor and do your homework. Most financial advisors will tell you that, generally speaking, the more years you have left toward retirement, the more risk you are able to take on in order to attempt to build a larger retirement fund. If you are very close to retirement, an annuity may be the very best choice for you because of the guaranteed lifetime payments. However, if you have a number of years left before retirement, other factors may come into play, e.g., the high administration fees, which may make an annuity a poor choice for you.

Additionally, make sure you know what the rules are governing your annuity contract. Some rules have been established by the Internal Revenue Code, and the annuity must meet these rules in order to provide the tax shelter benefit to the investor. For example, tax-sheltered annuities must provide for penalties for early withdrawal. These normally include payment of the taxes that would have been incurred had the money been taxed at the time it was earned, together with an additional percentage as a penalty. Also make sure you are aware of the distribution rules for your annuity. For example, are you required to take the annuity in monthly payments for life? Or can you elect to elect to take the distribution as a lump sum payment? If so, can it be rolled over into another investment vehicle which will allow the money to continue to grow while you pay taxes only on the amounts you choose to withdraw? Does the annuity offer a meaningful death benefit? Or does the money in your account revert to the annuity in the event of your death?

All of these factors should be taken into consideration in choosing whether to invest in an annuity. Make sure to discuss these things with a trusted financial advisor before making a decision. As with any investment toward your future, it is important that you feel very comfortable with your decision before signing on the dotted line.

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