A Review of Tax-Deferred Annuities Part II

In our previous article on tax-deferred annuities, we discussed the three primary sources of retirement income as well as potential drawbacks of relying on Social Security benefits to cover expenses in retirement. We then introduced tax-deferred annuities, also known as TDAs, and brief information on how these accounts work. Today, we’ll wrap up our review of TDAs, providing more details as to the advantages this solution has in filling gaps created by other retirement income sources.

Tax Advantages of Tax-Deferred Annuities

In our previous article, we learned that in TDAs, taxes are paid on the income distributions just as if they were regular income, but the premiums and interest growth (earnings) are tax-free. An additional tax benefit is that any contributions made to a TDA are “pre-tax”; they are not reported as income, giving account holders a chance to lower their taxable income amounts equal to the amount of any contributions to the account.

When it is time to withdraw money from the account once retirement age is reached, ordinary income taxes apply, as these withdrawals are seen as ordinary income. If an account holder should withdraw money early (before the age of 59 ½, the amount withdrawn is subject to a 10% early withdrawal tax penalty.

These tax advantages are superior to other potential retirement income sources. The tax-deferrals may allow individuals to accrue more funds and at a faster rate than would otherwise be possible with other retirement plans. A qualified tax professional can help you to understand how these tax advantages can be applied to your unique financial situation as you prepare for retirement.

Putting TDA Tax Advantages to Work

For those who qualify for a TDA, the tax advantages can be very substantial. In very simple terms, those eligible for a TDA can use pre-tax dollars to set up a retirement fund; the money grows tax-deferred until it is time to withdraw money at retirement age. Pre-tax dollars are used to pay the premiums on these annuities, meaning that an account holder can subtract the amounts from their ordinary income, resulting in a smaller federal income tax payment.

The tax advantages pile up. Just how much can this benefit a person with a TDA? Here’s an example: two individuals each contribute $100 per month – one to a TDA, and the other to another retirement account. With the same hypothetical 5% rate of return, the person contributing to the TDA over 20 years will have $30,000 after taxes, while the person contributing to the other account will end up with just over $26,000 after taxes. That is an additional $4000 to have at retirement!

Information about TDAs

Now that we know what tax-deferred annuities are and what tax advantages they present to those planning for retirement, it’s time to go into further detail. Let’s take a look at some basic information on eligibility, contributions, and regulations.

Eligibility — Any employees of public school systems in the United States and employees of charitable, religious, educational, and scientific organizations registered as a 501(c)(3) non-profit are eligible to participate in TDA plans set up by their employers.

Contributions – any contributions made to a TDA are done on the behalf of the employer for their participating employees. Typically, these contributions are done using a salary reduction (called an elective deferral) or can be done instead of increasing the employee’s salary (called an additional contribution). Some plans allow for all of or a portion of contributions to be designated as a Roth contribution; in these cases, the contributions are considered as ordinary income and are subject to income taxes.

Excludable Amounts – for 2017, there are maximum limits on exclusions from an employee’s income. For salary reduction, the maximum elective deferral is equal to 100% of compensation or $18,000, whichever is the lesser value.

In cases where there is both an elective deferral and an additional contribution (see above), the total excludable amount is $54,000 or 100% of compensation, whichever is the lesser figure.

Additional Elective Deferrals – for the year 2017, a person participating in an employer-established TDA plan who is 50 years of age or older may contribute an additional elective deferral to the plan. This is limited to $6000 or the amount of the participant’s compensation minus any other elective deferrals taken that year, whichever is less.

Allowable Financial Investments – TDA investments must be done in fixed or variable-rate annuities, whether individual or group. Insurance products with incidental life insurance protection and/or custodial accounts that invest in mutual funds are also allowable investments. To help protect the TDA and its participants, the TDA itself must be nonforfeitable and cannot be transferrable by specific provisions in the contract.

Contributions are made on a pre-tax basis, saving the participant money in income taxes because these contributions are not considered part of ordinary income. There are limits to this excludable amount (see above).

Growth in the TDA plans continues tax-deferred until retirement age is reached and distributions are taken. Once distributions are taken, the amount or amounts are subject to income tax at ordinary tax rates. Remember that early withdrawal of funds from the account (before the age of 59 ½) can result in significant premature withdrawal tax penalties of 10%.

Once the taxpayer reaches 70 ½ years of age, he or she must begin to take minimum distributions from the plan by April 1st of the following year. If those minimum distributions are not taken, a 50% excise tax is levied on the difference between what funds were actually paid out and the amount that should have been paid under minimum distribution regulations.

Speak to a Tax Professional for More Details

Tax-deferred annuities, or TDAs, are a great solution for those who are eligible to participate in such plans. These tax-deferred accounts can be used to supplement or replace other sources of retirement income, helping to preserve a safe and stable financial future. There are many details one must consider before establishing a TDA account, and it is best to seek professional help. A qualified retirement tax specialist can help you determine if this financial solution is right for your future needs and your financial goals once you retire.

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