Tax-Sheltered 403 (b) Annuities & Exclusion Ratios

A tax-sheltered annuity plan (often referred to as a 403(b) plan or a tax-deferred annuity plan) is a retirement plan for employees of public schools and certain tax-exempt organizations. Generally, a tax-sheltered annuity plan provides retirement benefits by purchasing annuity contracts for its participants. An annuity contract is a financial instrument that converts a lump sum of money into a stream of income payable for life. The person who receives an annuity is called the annuitant.

As an annuitant, you may exclude a portion of the benefits you receive from a tax-sheltered annuity plan from your gross income. The fraction that may be excluded is calculated using an ''exclusion ratio.'' The exclusion ratio is based on the amount of your premiums or other after-tax contributions. The exclusion ratio enables you to recover your after-tax contributions tax free. You pay taxes on the remaining portion of benefits, which represents income.

Calculating the Exclusion Ratio

The exclusion ratio is your net investment in the plan (amount of premiums paid for the annuity) divided by your expected return from the plan. The expected return is the total amount of annuity payments that you'll receive. Generally, an annuity provides for lifetime payments, so the total amount of annuity payments depends on your life expectancy at the annuity starting date. For example, if your net investment is $100,000 and the expected return is $300,000 then the exclusion ratio is .33 (100,000 divided by 300,000).

Amount Excluded from Gross Income

After you determine the exclusion ratio, you can calculate the portion of an annuity that will be excluded from taxation. You start with the amount of the annuity that was received and multiply that amount by the exclusion ratio. Continuing with the example above, if you receive an annuity payment of $20,000 in one year then the amount that will be excluded from taxation for that year is $6,600 (20,000 multiplied by .33).

Excluded Amount Not Entered on Tax Return

The amount excluded from gross income using the exclusion ratio calculation isn't included in your total wages on Form W-2. This means that the excluded amount doesn't need to be reported on your tax return.

No Exclusion after Investment Recovered

After recovery of your investment in your annuity, any additional payments are included in gross income and the exclusion ratio isn't applied. Typically this does not occur until many years after the annuity starting date and by that time, it's common to be in a lower income tax bracket.

Questions for Your Attorney

  • I am a teacher at a public school and would like to know if my employer is required to offer a tax-sheltered annuity plan?
  • Will a 403(b) plan generally provide enough funds for retirement or are additional retirement plans necessary?
  • Can I make contributions to my tax-sheltered annuity plan after I retire?
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