Tax Sheltered Annuity Traps

Posted by Badger Coach on June 9th, 2014

Retirement plans established for employees of public schools and state colleges and universities, as well as employees of religious organizations and other non-profit 501(c)(3) institutions, may invest in what is known as a 403(b) plan or Tax Sheltered Annuity (TSA). These plans have many of the same characteristics as their 401(k) cousin, but they also have some very important differences. For the purposes of this discussion, I will refer to 403(b) plans as a TSA.

What Do You Know About Your TSA?

TSAs come in two flavors—variable annuities and fixed annuities. Variable annuities cost significantly more to invest in, and they offer no guarantees because your deposits are invested into the stock market. Unlike fixed annuities, variable annuities cannot offer you guaranteed income for life. On the other hand, fixed annuity fees are much less than variable annuity fees and your money is not deposited into the stock market. Only the fixed annuity can provide you with guaranteed income for life.

TSA Taxation

Like the 401(k) plan, TSA participants may make contributions on a pre-tax basis and pay income tax on the withdrawals during retirement. And like the 401(k) plan, withdrawals prior to age 59½ may incur a 10 percent IRS penalty. TSAs are also similar to 401(k) plans in that employee and employer contributions are treated as wages for Social Security and Medicare tax purposes. This means that you must pay Social Security tax (6.2 percent) and Medicare tax (1.45 percent) on your (elective deferrals) contributions before they are deposited into your retirement account. This is what I call a  TSA contribution tax. If this comes as a surprise to you, don’t feel bad because many insurance agents, financial advisor’s, and accountants are also unaware of this fact.

To help you gain a better understanding of how your TSA money is taxed, the IRS states the following:

  1. Generally, employees must pay social security and Medicare tax on their contributions to a 403(b) plan, including those made under a salary reduction agreement, and …
  2. Allowable contributions to a 403(b) plan are either excluded or deducted from your income, and you do not pay income tax on allowable contributions until you begin making withdrawals from the plan, usually after you retire.


What this means to you is that contributions that you and your employer make to your TSA account do not count as income and may be deducted for federal income tax purposes. However, employee and employer contributions are counted as income for Social Security and Medicare tax purposes. Uncle Sam wants his money first. For example, if you contribute $250 per pay period towards your TSA account and your employer matches your contribution for a total of $500 per pay period, depending on your federal income tax rate, you may deduct a percentage of the $500 for federal income tax purposes.  However, Uncle Sam will hit you with a TSA  contribution tax of 15.3 percent before your money is deposited into your TSA account. As you can see, Social Security and Medicare tax completely destroy any benefits of an employer match. The good news is that your employer covers half of this tax.

So, the next time you are in a retirement class at work and the sales rep tells you that you are using pre-tax dollars when you invest in your TSA account, you now know that this is not completely accurate.

TSA Variable Annuity Fees

If you decide not to use a fixed annuity and opt for the variable annuity, Morningstar estimates that the average all-in expense for a variable annuity is approximately 2.30% (excluding income riders). So, if we use 2.30% as an average annual variable annuity fee and assume your school system, university, hospital, or church employer is not matching your contributions, you will pay a total of 9.95% in Social Security tax, Medicare tax and investment fees to invest in your TSA variable annuity. And if your employer does match your contributions, you will pay a total of 17.6% (15.3% as discussed earlier + 2.30%) to invest in a TSA variable annuity.

TSA Cost Benefit Analysis

The primary goal of investing is to get out more than what you paid in. To illustrate why fees and taxes matter, consider the following example: If you were to contribute $250 per month for 35 years, and you earned 8% each year, and you were charged an annual fee of 2.25% to invest, you would have an ending account balance of $331,000.  However, you would have contributed $105,000 of your own capital, paid $8,000 in TSA contribution taxes and $93,000 in fees, for a total cost of ownership of $206,000. The net profit over 35 years is $125,000. What this means to you is that you paid in more ($206,000) than you are going to get back ($125,000). These numbers do not include the income taxes that you will have to pay upon withdrawal of your money, which—if added—would decrease your net profit even more. And to add insult to injury, in this example, the annual investment APY drops from 8% to 1.51% when total cost of ownership is taken into account.

TSA Rolling Surrender Schedule

Whether you own or are about to purchase a fixed or variable TSA annuity, you need to be aware of what is called, a “rolling” 10-year surrender schedule. This schedule requires that every time you make a contribution, that specific contribution may not be withdrawn for 10 years or the insurance company will charge you a hefty fee. So, if you have only five years left before you retire, some of your TSA money will have to sit in that account for another 10 years, which is long after you have separated from your employer. Most of the agents selling fixed or variable TSA annuities do not want you to know this important piece of information. If you feel the need to invest in a TSA, make sure you invest in a non-rolling surrender schedule TSA. If your agent does not know what this is, or acts like they do no know what you are talking about, call the customer service number of your TSA annuity provider and find another agent.

TSA and the Employee Benefits Department

In addition to the high fees and TSA contribution tax, TSA participants have a much bigger problem to worry about—the employee benefits department. The employee benefits department is in charge of the types of annuities offered to its employees. Unfortunately, if you do not like your particular TSA, the only option you have is to roll it over to another TSA provider listed on the approved vendor’s list. The problem with this is you may be going from a sub-standard TSA to a terrible TSA.

TSA Information

If you are looking for some additional information regarding 403(b) plans, visit


If fees, taxes, and investment risk are low, 403(b) TSAs can be an excellent retirement vehicle for individuals earning more than $117,000 annually because beginning in tax year 2014 they are excluded from paying Social Security and Medicare payroll tax. Medicare tax may be imposed on higher incomes. For individuals earning less than $117,000 annually, a TSA/401(k) alternative retirement savings approach may be warranted. And finally, your 403(b) plan is not a tax savings plan. It is a tax-delayed plan. If taxes are higher during retirement, contributing to a 403(b) plan may not be a wise thing to do. For more information enjoy reading the article entitled–401(k) is For Losers.




The opinions expressed are those of the author and is for educational purposes only, and not an offer to buy or sell securities.  Use this information at your own risk. Investing involves significant risk, even the loss of capital. Invest only what you can afford to lose. Past performance is not indicative of future results. Guarantees provided by an insurance company are based on its claims paying ability. Policy loans will reduce the death benefit, until repaid in full.  Upon termination (not death of policy holder) of a policy, unpaid loans and the accrued/capitalized interest will be taxed as ordinary income.   Unpaid policy loans may be  taxed at ordinary income tax rates in the year of the  lapsed, surrendered, or terminated policy. As always, please consult with a qualified legal, tax, insurance or investment professional before making any investment or insurance decision.



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