Section 403(b) of the Internal Revenue Code allows an individual to exclude from his or her taxable income a portion of salary that is contributed to an annuity contract. The amount an investor may contribute varies according to such factors as length of service, employer contributions, etc. The advantage of that kind of saving is clear: Although the individual's salary is reduced by the amount contributed to an annuity contract, that individual pays federal income tax only on the remaining portion of the salary. In that way, money that would have been paid in taxes is instead working for the investor.
With an annuity account, investors' tax-deferred payments -- and their earnings on those payments -- continue to accumulate until the investor retires. Investors pay no taxes on contributions to annuities or on the interest that annuities earn until they withdraw the money from the plan. At that time, an investor can elect to begin receiving monthly income payments from his or her annuity account. The portion of the annuity account that has accumulated on a tax-deferred basis will be taxed as ordinary income in the year it is paid out -- when the investor's reduced income during retirement is likely to place him or her in a lower tax bracket.
Under federal guidelines, any taxable funds an investor withdraws before turning 59 may be subject to an additional 10 percent penalty tax unless the withdrawal meets one of the exceptions outlined in the Internal Revenue Code.
The benefits of a tax-deferred annuity are more clearly shown by the illustration below. In the example, the individual's annual salary is $24,000. The individual in the illustration contributes $3,000 of that salary to an annuity, so his or her gross taxable income is $21,000.
That reduced income level might place the investor in a lower tax bracket, which could (1) reduce the amount of taxes deducted from the investor's paycheck and (2) increase the investor's take-home pay.
Without a tax-deferred annuity, the individual in the illustration would pay taxes on the full amount of his or her salary. That could mean a tax increase and a reduction in take-home pay take-home pay. The illustration shows the net effect of saving that same $3,000 in an after-tax savings vehicle.
 | With Tax-deferred Annuity |
Without Tax-deferred Annuity |
Annual Salary | $24,000 | $24,000 |
Tax-Deferred Annuity Payment | -3,000 | ---- |
Taxable Income | 21,000 | 24,000 |
Federal Income Tax (28%) | -5,880 | -6,720 |
Net Income | Â | 17,280 |
After-Tax Investment | ---- | -3,000 |
Spendable Income | $15,120 | $14,280 |
The following illustration demonstrates the power of tax-deferred growth. It illustrates how much more an investor can accumulate through tax-deferred growth than through earnings that are taxed each year.
 |  Annuity Contract |
 Taxable Investment |
Payment | $3,000 | $3,000 |
*Net Investment Return Averaged 5% | 150 | 150 |
Balance at End of Year | 3,150 | 3,150 |
Amount reported to IRS as Interest Income | -0 | -150 |
Income Tax Due (28%) | -0 | -42 |
Net Earnings | $150 | $108 |
To illustrate how overall tax deferral benefits an individual, suppose an investor sets aside $3,000 each year for 20 years and that those contributions earn 5 percent interest annually. After 20 years of depositing funds in a tax-deferred annuity, that investor would have $15,356 more than if he or she had contributed to a taxable investment.
The illustration to the right shows a net interest rate after-tax equivalent to 3.6 percent. The projection assumes payments made on a monthly basis and is only an example. It does not reflect the current rate and exceeds the guaranteed rate. It is intended to show you how the policy works.
Tax-deferred means that you do not pay income tax on the earnings or investment gains of retirement plans until you withdraw the money. It is important to realize that you eventually pay income tax on the tax-deductible contributions to your retirement investments and on their tax-deferred earnings. You may also pay a penalty tax if you withdraw your retirement investments before you are 59 years old. Each is an "envelope" into which you contribute your retirement savings and then select the type of investment that is appropriate.
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