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403(b) / TSA Plans for Teachers

What is a 403(b) Tax Sheltered Annuity? A Tax-Sheltered Annuity (TSA), also known as a 403(b) plan is named after a section of the Internal Revenue Code. It is an employer sponsored retirement savings program. Participation is limited by law to employees of public educational organizations and certain nonprofit organizations. The vast majority of participants are teachers in public schools, colleges and universities. Contributions to a TSA are made for the participating employee by his or her employer. The money that is contributed to the TSA comes either from employer contributions - which are called non-elective deferrals, or from employee contributions, called elective deferrals. Elective deferrals are deducted from the participant's paycheck and forwarded to the insurance company or mutual fund custodian selected by the participant. The participant signs a salary reduction agreement giving the employer the authority to make the paycheck deduction and remit it to the chosen company. Most TSA contributions are elective deferrals. You may contribute 100% of your compensation subject to the elective deferral limit of $11,000 for 2002. This limit increases by $1000 per year for each of the next four years so it will be $15,000 in 2006. For individuals age 50+, an additional $1,000 can be contributed for 2002, making the deferral limit $12,000, This amount also increases by $1,000 per year for each of the next four years reaching $5,000 in 2006. If a 403(b) participant has 15 or more years of service, they may be eligible for an additional "catch-up" provision. A "catch-up" provision of $3000 is available only if the participant has not contributed on average more than $5,000 per year into a 403(b) account. An averaging calculation must be done to ensure that the option is available. A lifetime limitation of $15,000 applies to this special "catch-up' provision.   Questions and Answers About 403(b) Tax-sheltered Annuities Note: We cannot give legal, tax, or accounting advice. The following general information is our understanding of current tax laws and regulations for 403(b) Tax-Sheltered Annuities. Please consult your own attorney, accountant, or tax advisor for advice about your own situation. Introduction This guide is an attempt to explain, in easily understood terms, the workings of a 403(b) Tax-Sheltered Annuity. In addition, we address some issues of current concern, including the soundness and financial strength of the life insurance industry, and how life insurance companies differ from other financial institutions. We briefly explain how an annuity company operates, and we make suggestions on how to choose an agent and how to set up your TSA to your best advantage. Since not every issue addressed in this guide will interest every reader, it is written in question and answer format. By consulting the Table of Questions, you may quickly turn to those topics that interest you. In this guide, the terms 403(b) and Tax-Sheltered Annuity (TSA) mean the same thing.   What is a Tax-Sheltered Annuity? A Tax-Sheltered Annuity (TSA) is otherwise known as a 403(b) plan, named after a section of the Internal Revenue Code. It is an employer sponsored retirement savings program. Participation is limited by law to employees of public educational organizations and certain nonprofit organizations. The vast majority of participants are teachers in public schools, colleges and universities. Contributions to a TSA are made for the participating employee by his or her employer. The money that is contributed to the TSA comes either from employer contributions — which are called non-elective deferrals, or from employee contributions, called elective deferrals. Elective deferrals are deducted from the participant’s paycheck and forwarded to the insurance company or mutual fund custodian selected by the participant. The participant signs a salary reduction agreement, giving the employer the authority to make the paycheck deduction and remit it to the chosen company. Most TSA contributions are elective deferrals, meaning that the participating employee supplies the money to make the contributions.   What are the Advantages of Participating in a TSA? Congress recognized the importance to our society of certain professions, including teaching, and the important role played by nonprofit organizations. Therefore, a tax break was granted in the form of a special retirement plan — a 403(b) plan.. The employer must sponsor a 403(b) plan, but installing and maintaining a typical TSA program is relatively simple and straightforward compared to other types of retirement plans. As the name Tax-Sheltered Annuity implies, contributions made on your behalf are not currently taxed, with income tax deferred until the premium and interest earned are withdrawn at retirement. To illustrate the tax advantage of a 403(b) plan, suppose you are a teacher earning $35,000 this year. If you elect to put $5,000 in a TSA through a salary reduction agreement, you will pay income tax on only $30,000, with the tax on the $5,000 contribution deferred until you withdraw the money at retirement. Both your contributions and the interest earned are tax-deferred until retirement, compounding the powerful tax advantage of a TSA.   Why Should I Participate in a TSA? While most state teacher retirement plans provide liberal retirement benefits, chances are your teacher retirement plan or other employer sponsored retirement program will not provide enough income after retirement to enable you to maintain your standard of living. A TSA permits you to accumulate money on a highly tax favored basis, to supplement teacher retirement or another retirement plan. The powerful tax break granted by Congress, combined with the power of compound interest (the time value of money), permits large sums of money to be accumulated over a period of years. An intelligently planned and funded TSA, together with teacher retirement, can make the difference between a comfortable retirement and the unhappy alternative. How Much May I Contribute to My TSA? The Maximum Exclusion Allowance calculation was repealed effective January 1, 2002. You can now contribute 100% of your compensation subject to the elective deferral limit of $13,000 for 2004. This limit increases by $1,000 per year for each of the next two years so it will be $15,000 in 2006. For individuals age 50+, an additional $3,000 can be contributed for 2004, making the deferral limit $16,000. This amount also increases by $1,000 per year for each of the next two years reaching $5,000 in 2006. What Forms of Investment are Available? The law permits TSA contributions to be placed in a fixed dollar annuity, a variable annuity, or a 403(b)(7) custodial account. Fixed and variable annuities are offered by life insurance companies, while 403(b)(7) custodial accounts are sponsored by mutual fund organizations.. Many participants choose a fixed dollar annuity. The fixed dollar annuity is popular because it is thought to be the safest and simplest of the three alternatives. The insurance company receives the contributions on your behalf, invests them, usually in bonds and mortgages, and credits you with interest on your money. The company must absorb any investment losses and may not pass them directly along to your account. What you receive is interest on your money, and in that respect a fixed dollar annuity is similar to a savings account at a bank. It is, however, a tax favored savings account. A variable annuity is more complex than a fixed dollar annuity. Variable annuities offer a choice of investment alternatives ranging from fixed accounts to growth stocks, income stocks, bond funds and so on. With a variable annuity you bear the investment risk, while with a fixed annuity the risk is borne by the insurance company. If you are in a variable annuity growth stock fund, for example, and the stock market goes up sharply, you stand to earn more than you would that year in a fixed dollar annuity. On the other hand, if stocks go down, you must accept the loss. A 403(b)(7) custodial account is nothing more than a mutual fund selected by you from a range of choices offered by your employer. There are many mutual funds from which to select, ranging from conservative, low-yielding money market accounts, to high risk small company growth stockfunds, to junk bond funds — anything which you might be interested in investing is probably available. Naturally, you accept all investment losses and you get to keep any gains. Why are Fixed-Dollar Annuities So Popular? The fixed dollar annuity is considered to be the least risky type of TSA. It works very much like a savings account at a bank, in that you earn interest on your premium. You don’t have to worry about the stock market or about bond prices since the investment risk is assumed by the insurance company. If you choose a fixed dollar annuity, the interest rate you will receive on your money will fluctuate over time, in line with the insurance company’s investment earnings. The premiums paid do not fluctuate up and down, but the interest rate varies according to the yield earned by the insurance company on its investments. However, the interest rate credited can never be less than the guaranteed rate (usually 3%). It helps to understand how the insurance company determines interest rates on fixed annuities. The company receives your contributions, which are called premiums. The premiums are invested, usually in bonds and mortgages, and the company earns a return on the investments. The company keeps a small amount to cover its costs and earn a profit, and credits the rest to your account. What the company keeps is called the spread, which varies by company and by product. The spread is measured in terms of basis points, with 100 basis points equaling one percent. Typically, a spread of 150 to 200 basis points is required by the company for its expenses and any profit. So if the company can earn 10% interest on its investments and is working on a spread of 175 basis points, it can credit 81/4% interest to your TSA. Keep in mind that for its 150 to 200 basis point spread, the insurance company must not only pay all the expenses associated with issuing and servicing the business, but must absorb any losses associated with the investment portfolio. For example, if any mortgage loans default, the company must absorb the loss and is not permitted to pass the loss along to you directly. That is why it is called a fixed dollar contract. While writing TSAs can be profitable for the insurance company, it must write a large number of annuities in order to generate the volume needed to make money. For the consumer interested in a competitive rate of return and safety, the fixed dollar annuity is a superb choice. For those with more investment expertise and who understand and are willing to accept the risks and volatility inherent in the stock market, bond market or real estate market, a variable annuity or 403(b)(7) custodial account might be appropriate. When May I Withdraw the Money in My TSA? Under current law, you may begin withdrawals at any time once you have attained age 591/2, and you are required by law to begin making withdrawals once you are 701/2. There are important exceptions to the general rules. If you separate from service with your employer prior to age 591/2, but on or after age 55, the law permits you to withdraw money from your TSA with no tax penalties or restrictions. If you separate from service prior to age 55, you are permitted restricted access to your money, but you must stretch out the distribution in a way that would systematically liquidate your account over your life expectancy. In other words, the amount you can withdraw each year is restricted. The good news is, once you have attained age 591/2 and if you have made systematic withdrawals for at least five years, current law permits you to revoke the previous withdrawal election and have full access to your money. When you reach age 701/2, if you have not already started withdrawing money from your TSA, you must generally begin doing so at that time. There are exceptions. If you are still working for an eligible employer, you may defer making any withdrawals until you actually retire. If you die before you have begun making any withdrawals from your TSA, your surviving spouse (if any) may become successor owner of your TSA. He or she will have the same rights as you had, except that no further contributions may be made. If your beneficiary is someone other than your spouse, he or she may take all the money at once or may stretch out the distribution over a period of years. The distribution rules are complicated and it is important to comply with them to avoid tax penalties. Your TSA company or agent can provide you with the information you will need. There is a reason for the withdrawal restrictions on your TSA. When Congress enacted the law creating 403(b) plans, it intended for you to use your TSA as a retirement savings vehicle, not as a short term tax-sheltered savings account. What is the Purpose of a Withdrawal Charge? Most fixed dollar and variable annuity contracts contain a temporary Withdrawal Charge. The Withdrawal Charge is a penalty assessed upon early withdrawal of the moneys in the account. In most cases the Withdrawal Charge grades down to zero over a period of years. The Withdrawal Charge serves several purposes. On a fixed dollar annuity, the insurance company must absorb any investment losses. Having a Withdrawal Charge permits the insurance company to invest in longer maturity investments with higher yields, and these higher yields are reflected in the current interest rate credited to your account. If there were no Withdrawal Charge, the insurance company probably could not afford to invest long term, and shorter term investments would mean lower interest rates on your annuity. The expenses associated with issuing and administering your annuity are higher initially than in later years. The Withdrawal Charge allows the company a period of time in which to recover its initial costs through the spread, described earlier. May I Borrow Against the Money in My TSA for Emergencies? Yes. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) makes it possible for you to borrow from your TSA. Most fixed dollar TSA contracts have a loan feature, as do some variable annuities. Loan provisions vary from company to company. The law permits you to borrow 100% of the withdrawal value of your TSA, if the loan does not exceed $10,000. If the amount borrowed exceeds $10,000, the maximum loan is 50% of the withdrawal value of your TSA not to exceed $50,000. By law, the loan must be repaid in at least quarterly installments of principal and interest over a period not to exceed five years, with one exception: if the purpose of the loan is to acquire a dwelling intended to be your principal residence within a reasonable time, the repayment period may be extended beyond five years with the agreement of the TSA company. When making a loan, first check to see what interest rate the company will charge you on the borrowed amount. Then, find out what interest rate will be credited on the accumulation value in your account set aside as collateral for the loan. You should take these things into consideration in deciding whether a TEFRA loan is better for your circumstances than borrowing from a bank or credit union. Suppose I Can Receive a Higher Rate of Return from Another Company. May I Transfer My Money? Yes. IRS Revenue Ruling 90-24 permits partial or full transfers of TSA funds between fixed dollar annuities, variable annuities and 403(b)(7) custodial accounts. There are some restrictions and rules, so consult your agent before making such a transfer. The general rule is that all transfers must be conducted directly between the companies at your direction. Under this procedure, you may not have the check made payable to you and then endorse the check over to the new company. In addition to tax-free TSA transfers, you are eligible to conduct a rollover of a full or partial distribution from a TSA or other qualified plan. A distribution may be made upon death, disability, separation from service with your employer or attainment of age 591/2. You may roll over a full or partial distribution of your TSA funds into another TSA or into an IRA. A direct rollover — where the first company sends the funds directly to the second one on your behalf — avoids the 20% withholding tax that must otherwise be deducted from the distribution. What is Meant by “Old Money” and “New Money” Interest Rates? The insurance company sets an initial interest rate, which is credited to new premiums as they are received. This is called the current interest rate on new money. As premiums are received and are invested, the company may place them in investment pools, and the rate of return on these pools is carefully monitored. When each contribution has been on deposit with the company for a period of time, the current interest rate is reviewed with reference to the earnings on the investment pool matched to that contribution. The company may then make an interest adjustment to bring the interest rate in line with the spread formula. For reputable companies, these adjustments are small, and are merely pricing adjustments required to maintain the target spread. Watch out for sharply lower old money rates. Some companies entice you to choose their TSA by offering especially attractive initial interest rates, then they sharply cut the old money rate. You may never know this unless you ask. If the initial new money rate seems especially high when compared to other companies, be skeptical. Chances are the company is trying to hook you with an appealing initial rate and may be planning to reel you in later with a much lower old money rate. In such cases, the Withdrawal Charge works against you by making it impossible to move your money to another company without sustaining a penalty. What is the Best Way to Withdraw the Money from My TSA at Retirement? The initial attention is quite rightly focused on setting up your TSA and selecting the product best for your circumstances. But attention should also be given to the vital questions of planning distributions from the TSA after retirement. All TSA annuity contracts, whether fixed dollar or variable, contain annuity payout options. Payout options, sometimes called settlement options, are different methods of systematically withdrawing the money in your TSA. A typical set of payout options will include life only, life with period certain, joint and survivor, installment refund and period certain only annuity payouts. All of these options are designed to liquidate the premium and interest in your account over a period of time that complies with IRS regulations for TSA distributions. In competition, companies often compare their annuity payout rates for life and ten year certain annuities for participants at age 65. This is an accepted benchmark for comparison within the industry. Yet in fact, experience shows that most TSA participants prefer to take their money out in other ways. Nothing in the IRS Code or Regulations requires election of a contractual annuity payout option. The IRS does require you to systematically withdraw the money in your TSA once you reach a certain age. This is called the required start date, and it is usually age 701/2, but not always (see “When May I Withdraw the Money in My TSA?”). Once you reach the required start date, each year you must withdraw a minimum amount in order to avoid a stiff 50% tax penalty imposed by the IRS on under distributions. The joint life expectancies of you and your spouse or beneficiary may also be used as the basis for this calculation, employing IRS tables for this purpose. Payout options come in two basic forms, lifetime and period certain. Lifetime payouts guarantee an income for life. Only a legal reserve life insurance company can guarantee a life income that lasts as long as you live. If you expect to live longer than the average person, a life only annuity can be an excellent choice. Period certain payouts systematically pay you the value of your account over a period of time you select. Choose your payout option with particular care, because usually it cannot be changed once it has been elected. A life expectancy payout (see page 12) is particularly attractive because of its flexibility. How Should I Go About Selecting an Agent? Choosing the right agent is very important. You need to be comfortable with your agent and his or her recommendations, and you need to feel you can work with that agent for a number of years. The recommendations made by your agent can mean the difference between a comfortable retirement and the less pleasant alternative. Use common sense in choosing your agent. A good agent will gladly answer questions and furnish references, and will not “high pressure” you. High pressure sales tactics are inappropriate for a TSA sale. What you need is information, and the best agents either have the information you need at their fingertips or will quickly obtain it for you. There are some agents in the TSA business — as in any other business — who are motivated somewhat more by the prospect of earning a commission than they are by serving your interests. These agents are in the minority and most TSA agents view seriously their responsibility to put your interests foremost. When you have found an agent with whom you are comfortable, stay with that agent and chances are you will be well served. Things to watch out for include an excessive number of recommendations to switch TSA companies. If you have chosen your company with care, there should be no need to switch companies unless something fundamental changes. If an agent wants you to change TSA companies every year or two, find out why. There could be a good reason, but the prospect of additional commission may be the motivating force. You are entitled to know. How is the Agent Compensated? Your TSA agent is paid by the insurance company for each annuity contract he or she writes. Typically, but not always, the first-year compensation is somewhat higher than in subsequent years. This recognizes the agent’s greater investment of time during the initial sale and delivery of the annuity. To compensate the agent for the annual service work that is required (calculating the exclusion allowance, giving advice and answering questions), renewal compensation is usually paid. Keep in mind that amounts paid to the agent are financed entirely from the company’s spread, described earlier. They are not deducted from your TSA account. There is an exception whenever a sales charge or front-end load is assessed on each contribution, but that is increasingly rare these days. Most TSA contracts sold today are so-called no load contracts. How Financially Sound are Life Insurance and Annuity Companies? The industry today is financially healthy and merits your confidence. In the early 1990s, several major life insurance companies failed because they followed poor management practices. For example, they invested heavily in so-called junk bonds or in poorly performing mortgage loans. Those companies were rehabilitated by state insurance regulators or merged into sound companies, and such problems are now behind the industry. While there may be a few individual companies with the insurance industry that merit some concern, the industry as a whole is quite solid financially. How Do I Judge the Financial Soundness of a TSA Company? Ask for the company’s ratings. Five nationally recognized rating agencies publish ratings on life insurance companies. In alphabetical order, these are A.M. Best Company, Fitch, Moody’s Investor Services, Standard & Poor’s and Weiss Research. What rating is acceptable to you is a personal decision. Most major TSA companies today are rated A— or better by A.M. Best Company, AA— or better by Fitch and/or Standard & Poor’s, A or better by Moody’s and C+ or better by Weiss Research. The Weiss rating system is much different than the other four rating agencies, and the differences usually result in much lower alphabetical scores. LSW, as an example, is rated A (Excellent) by A.M. Best, effective June 20, 2003. Ask the agent for financial information on the company you are considering, and ask questions about the company’s financial health. Bigger is not necessarily better, as the experience of the early 1990s showed. In closing, here’s some sensible advice based on many years of experience: First, choose a conventional annuity. Second, plan things so that when you retire, you have accumulated a retirement fund in your TSA that has no withdrawal penalty. Then, instead of electing a formal payout option, make withdrawals from your TSA as you need the funds to supplement your pension. Be sure to withdraw enough each year to avoid any IRS penalties for under distributions. If you plan things in this way, should your circumstances change and you need access to your remaining funds, they will be available to draw upon. Above all, do take advantage of the opportunity to participate in a TSA. It will be one of the most important financial decisions you make in your working career, and it will have a major, beneficial impact on your standard of living after you retire.

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