What is a Tax Sheltered Annuity?

In the United States, the Internal Revenue Code refers to any retirement savings account set up under the provisions of Section 403(b) as a “Tax Sheltered Annuity.” These accounts, commonly called “403(b)” plans or accounts, originally were restricted to investing only in annuities from the time the Section was established in 1958 until it was amended in 1974 to permit more investment options, including mutual funds. Available only to employees of public schools and certain other not-for-profit organizations, 403(b) plans became very popular in the 1980s as the non-profit alternative to 401(k) retirement plans, which were established in 1978.

Retirement security has been a pressing issue in the United States ever since the great depression of the early 1930s, when millions of families became destitute. The establishment of Social Security provided a measure of security, but that plan wasn't intended to be a retiree's total retirement income. Company-provided pension plans, usually of the defined-benefit model, became popular after World War II and on past the middle of the century, but as time went by, the financial burden on employers of these plans became onerous. On the other hand, many non-profit employers and public school systems provided no retirement program at all for their employees.

Section 403(b) of the Code was passed in 1958 to address the needs of public school teachers and other employees of not-for-profits because their employers often didn't have the assets to provide defined-benefit pension plans. School systems and other non-profits, at an almost insignificant cost, could allow each employee to set up a tax sheltered annuity and take advantage of the tax advantages associated with it. In 1978, Congress passed Section 401(k) of the Internal Revenue Code, which shifted the burden of retirement savings from employers to the employees themselves. These plans were oriented generally toward equity investing — primarily mutual funds in stocks and bonds, and money market accounts.

Participants in both 403(b) and 401(k) plans are permitted to save money from their earnings on a pre-tax basis — that is, the money is deducted from their pay and put into the retirement savings plan before being taxed. The contributions, together with any earnings, are permitted to grow without being taxed until withdrawn. If withdrawn before age 59 1/2, the proceeds are taxed as ordinary income and in most cases, a significant penalty is added.

Another approach to retirement savings planning, the Roth account, can be implemented in both plans. Contributions to a Roth account are made on a post-tax basis, but the earnings of a Roth account are tax exempt. A tax sheltered annuity may be set up as a Roth account.

The term “Tax Sheltered Annuity” used to describe 403(b) plans is perhaps archaic because not only are annuities just one of the investment options available, every annuity is a tax sheltered annuity, whether purchased through an employer-provided plan like a 401(k), 403(b) or other special plan, or simply purchased independently by a consumer.