Teachers, school personnel, doctors, nurses, hospital employees, and members of nonprofit organizations are eligible to participate in a retirement plan referred to as a tax-sheltered annuity (TSA) under IRS Code Section 403(b). TSAs offer advantages not found in other types of annuities and retirement plans. While the market for these types of annuities are quite large, many, if not most, of the persons that can purchase TSA’s are served by large insurance agencies that have arrangements with particular schools, school districts, hospitals, etc. Therefore, some agents will never have an opportunity to market TSAs, but if the agent is with one of the large agencies that specialize in this type of business, it can prove quite profitable.
TSAs are simply annuities purchased from an insurance company and sold to those as mentioned above. The “participants” have a choice of either a fixed annuity, or a Variable Annuity. These annuities may be issued either on an individual basis, but many times on a group basis since the insurer receives contributions on a payroll basis – they are named on a pre-tax basis. Even though the premiums are paid on a pre-tax basis, the Social Security taxes are withheld on the salary reduction amount.
Tax-sheltered annuities (and other types of 403(b) plans) are intended to provide retirement benefits, with some stipulation that funds can be released prior to retirement if there is financial hardship, death, disability, or termination of employment.
TSA’s can be either individual or group, as stated above, and the individual contract differs from the group inasmuch as the individual in the plan receives their own contract. If a person is under a group contract, the participant receives a certificate, which states that the agreement is between the insurer and the employer. This is common practice for group insurance and TSA’s are no exception.
FThe big difference between individual and group TSA’s, is in the area of flexibility.
Individual contracts, for instance, have certain guarantees that last until the contract is terminated. Group plans, on the other hand, have certain guarantees or assumptions that last for a specified period of time, such as 5 years. But the big difference is portability.
Under an individual contract, if the individual changes jobs, they may do one of several things: freeze the account, transfer part (or all) of the account to a new employer’s program (if they have a TSA program), or rollover the funds into an IRA. Regardless of which action is taken, the account will be allowed to grow and to compound tax-deferred. If the Section 1035 rollover is accomplished properly, no tax event will be triggered.
While moving a TSA to another plan can escape the IRS penalties and taxes, there may be withdrawal charges from the previous insurer. Group contracts, in particular, may contain some sort of withdrawal fee, not usually the situation with individual plans.
Obviously, the attraction of the TSA plan is the income tax implications. In a nutshell, there are three major tax benefits:
While contributions are being made to the plan on behalf of the employee by the employer, these contributions are made with before-tax dollars, and can be made bi-weekly, semi-monthly or monthly (usually), and the insurer then deposits the contribution (or most of it – see next paragraph) into the participant's account. The actual investment is determined by the options available and those elected by the employee.
When these deposits are made, there may be a transaction charge (thereby reducing the contribution). There can also be a maintenance fee deducted from the account balance. Some companies may instead levy an expense charge when the funds are withdrawn.
When the participant is ready to receive the distribution, they may take it out in a lump sum; make a partial withdrawal of a part of the total funds available; rollover the account into another TSA or into an IRA; or they could annuitize the contract and start receiving periodic payments.
If the contract is annuitized, the amount of the payment will depend upon the rate offered by the insurance company, the amount being annuitized of course, and the annuity option selected by the participant. Recently, some insurance companies allow the contract owner to select either a fixed or a variable account during payout, regardless of whether the contract was variable or fixed originally.
The participant must understand that there will be no guarantees as to the amount of the monthly benefit if they choose a variable account. The insurer assumes and states an assumed interest rate of return. If the account does well (the invested amount) the monthly benefits will increase, if it does poorly, they will not increase.
The two most common methods used to determine the current interest rate to be credited to employees' accounts are the (1) portfolio average and (2) banding methods. The “portfolio average” is determined by the insurer's earnings on its entire portfolio during the particular year and all policy owners are credited with a single composite rate. On the other hand, the banding approach uses a different technique that changes from year to year. All employee contributions are treated as one amount (banded) and each account is credited with the actual yield that the deposits actually earn. If, for instance, during the present year the money contributed is receiving 9%, then that is what the individual will receive. If, however, the previous year these funds had only earned 8%, then part of the portfolio will reflect 8% and part 9%. This method is best for the investor when interest rates are rising, when interest rates are declining, the portfolio method is best.
FWARNING. It is not wise to compare the current rate of return between insurers, as the methods of determining the return vary widely from company to company.
It is estimated that about 70% of all TSA contributions are made by the employee and the remaining 30% are made by the employer. The insurance company specifies the details, with no more than the IRS limitations on contributions. The employee's paycheck may be reduced by either a specified dollar amount, or a percentage or a percentage of pay and are sent to the insurer on a specified schedule – usually monthly.
Contributions can also be made by the employee transferring funds from one insurance company to another, or even from one sub-account to another sub-account offered by the same insurer. The reasons for transfer are various, but can include the employee’s general dissatisfaction with the current portfolio's performance. Of course, if the employer is changed &/or the new employer does not offer TSAs, this can be a definite reason. Other reasons could be that the investor’s retirement date has changed, or simply the investor is not in a position where they want a fixed plan instead of a variable plan, as they have no interest or ability to continue to take a risk.
When the employee retires, there are several options open.
1. They can withdraw all of the account – a total withdrawal.
2. They may elect to just leave the money where it is and let it grow.
3. They may decide to annuitize, and use either a fixed rate or a variable contract.
4. They may decide to simply take out the account balance in form of payments over a particular time period.
5. Perhaps they will just transfer the balance to another insurer.
6. They could possibly use a 1035 exchange and rollover the account to an IRA (that may be invested in another annuity).
If the person decides to transfer the entire account to another insurer that may offer a better annuitization schedule, make sure that all withdrawal costs are spelled out.
If the person decides to annuitize, the type of plan should depend upon the particular person’s situation. For instance, if the health is bad, a straight life annuity is probably not a good choice, but a life annuity with period certain or a joint and last survivor option should be seriously considered. If there are those dependent upon the employee and who will continue to need financial assistance after the death of the annuitant, the same recommendation could be offered to them as if the health of the annuitant was bad. If there are no dependents, a life annuity would provide the highest payouts. But, if the person retiring does not want to outlive their income, a life option should be considered, in lieu of a lump sum or installment option.
Some companies may allow a contract holder to borrow part of the TSA, however there are certain IRS regulations that restrict the amount and period of the loan, as follows:
The insurance companies also may have rules and restrictions regarding loans, for instance they may require that a certain minimum be loaned out and that a certain amount remain in the investment after the loan is made. Those companies that permit loans may also charge a fee when a loan is taken out, and it may be stated as an administration or maintenance fee. And to top it off, there is a provision in the TSA contract that allows insurance companies to charge interest on the amount of the outstanding loan. The interest charged may be either a flat fee, or tied to an index and generally, second loans are not allowed until the first loan is fully repaid.
It should also be understood that a late payment (sometimes considered a “technical default”) may be deducted from the remaining funds in the individual’s account. This can have adverse tax and penalty consequences. It is important that this be thoroughly understood by the employee.
As with nearly all annuity contracts, there is no fee or penalty for a liquidation due to the death of the participant. In those rare cases where a penalty is levied, it would usually take the form of an interest reduction.
When the employee dies, most companies will automatically pay out the total account value to the beneficiary. The beneficiary may receive the funds either in a lump sum, or may elect to annuitize the contract. Some insurers offer other payment options also.
As with every insurance company policy and investment vehicle, there are certain expenses inherent in the business. Some of these are more readily identifiable, which are called “explicit” fees. Other fees, not so obvious, are called “implicit.” The explicit fees are stated in the contract, and are applied throughout the year and are triggered by certain business situations. Examples would be when the account is valued, when a contribution is received, the granting of a loan, or the making of a withdrawal.
Implicit charges are indirect charges and in some circumstances, may be much higher than explicit charges. One such implicit charge could be a charge against the difference between the returns actually made by the insurer, as compared to the amount credited to the account. Another implicit charge could occur when the contract is annuitized, and would reflect the difference between what the individual receives and what the account actually earns, plus expense charges. Many times implicit charges can be ignored and in too many cases, underestimated.
The insurance companies have quite broad privileges to alter, change, or amend TSA contracts. This can include actions that can affect the amount of charges, the amount of interest credited to the account in the future, the annuity rates on the amount annuitized, and other such provisions. It certainly behooves the professional agent to become familiar with any such provisions, and to makes certain that the client fully understands what they entail. The good news is that generally only group contracts can be altered without the permission of the employee. While individual TSAs can be changed, they can be changed only with the approval of the investor.
When an annuity has a death benefit payable to a beneficiary, the exclusion ratio still applies under certain circumstances. If the annuitant dies after payments have begun in the liquidation phase, the beneficiary must receive the death benefit in installments, either on the same schedule as the deceased or faster, in order for the exclusion ratio to be used.
STUDY QUESTIONS
1. Under IRS Code Section 403(b), who are (is) entitled to participate in a retirement plan which
is “tax-sheltered?”
A. Any individual who is not covered under an employer’s group retirement plan.
B. Any person under the age of 70 ½.
C. Only teachers, school personnel, doctors, nurses, hospital employees and members of
nonprofit organizations.
D. Persons not covered by an employers retirement plan.
2. Funds under a 403(b), or TSA, plan
A. may not be released prior to retirement under any circumstances.
B. may be released prior to retirement only if rolled over into a 401(k) or an IRA.
C. can be released prior to retirement if there is financial hardship, death, disability or
termination of employment.
D. maybe released prior retirement only in case of death of the annuitant.
3. The biggest difference between individual and group TSAs is
A. flexibility.
B. termination requirements.
C. tax treatment.
D. commissions.
4. Contributions to a TSA are made with
A. employer funds only.
B. pre-tax dollars.
C. after-tax dollars.
D. cash-out of IRAs.
5. The participant in a TSA may receive the distribution
A. only in a lump sum.
B. lump sum, partial withdrawal, rollover into an IRA, or annuitize and receive periodic
payments.
C. only in periodic payments.
D. after it has been distributed to a federally chartered bank.
6. With a TSA, using a portfolio average or banding method are descriptions of methods used
A. to determine the current interest rate to be credited to the employee’s accounts.
B. to determine how much of the distribution will be taxed as ordinary income.
C. to determine how much of the distribution can be rolled over into an IRA tax-free.
D. to determine the commissions to be paid to the agent.
7. When the employee covered by a TSA retires
A. they must take all of the money in a lump sum.
B. the funds are combined with Social Security so not as to exceed $2,000 per month.
C. they may not roll it over into an IRA that is invested in another annuity.
D. they have several alternatives as to distribution.
8. If a TSA participant wants a loan against the annuity
A. they must withdraw all of the account.
B. the loan is tax-free, regardless of the amount.
C. there are several IRS regulations that restrict the amount and period of the loan.
D. it must be taxed regardless of the amount or circumstances.
9. In order for the exclusion ratio to be used with a TSA when the annuitant dies after payments have begun,
A. the beneficiary must receive the payments in a lump sum.
B. the TSA must be converted to an IRA.
C. the beneficiary must receive the death benefit in installments.
D. the amount of the annuity must exceed $200,000.
10. An expense charge against the difference between the returns actually made by the insurer, as compared to the amount credited to the account,
A. is an implicit charge and would be stated in the contract.
B. is an implicit charge and is not stated in the contract.
C. is an explicit charge but would not be stated in the contract.
D. is an explicit charge and would be stated in the contract.
1C 2C 3A 4B 5B 6A 7D 8C 9C 10B