Retirement is a really scary topic to start with. Whether preparing for retirement or not, age will catch up. One can have many retirement investment plans, and a tax deferred annuity plan is one of them.
A tax deferred annuity investment plan is a viable saving plan that millions of Americans nearing retirement with no savings can consider.
In the majority of cases, a tax deferred annuity plan is sponsored by employers. Here, an employer agrees with their employee on a salary cut channeled to their Tax Deferred Annuity.
How Does Tax Differed Annuity Work
Let’s break this down word by word.
To start by, the term “tax deferred” means that payment of taxes is postponed for a future date. Below is the logic:
When your employer pays you, a percentage of your salary is remittable as income tax. When a portion of your salary has been deducted before you receive it and it is channeled to an annuity plan, this amount is not taxed.
By default, it lowers the amount of salary you receive from your employer. The amount you receive from your employer lowers the tax gap where your salary falls.
The government makes its money from taxes, and every penny must be necessarily taxed. If the amount channeled to an annuity plan by the employer is not taxed, this will result in tax evasion. To avoid using annuity for tax evasion, the government comes to you in future to collect its taxes on the proportion of salary that never got taxed at the origin (employer).
Tax will not be collected on your annuity principal while still with your insurer. Instead, necessary taxes will be effected the very moment you activate the first withdrawal of your annuity distributions.
The aspect of postponing income taxes on your salary to pay them in the future creates the essence of “deferred tax.”
Tax Deferred Annuity Plan Contribution Limit
Employers do not always sponsor a tax deferred annuity plan. However, since this is the most common form of tax deferred annuity, it has a limit established by the Internal Revenue Service for the 403(b). This limit changes from year to year as needed.
As of 2023, the maximum amount you may use your salary to fund a tax deferred annuity plan is $22,500. However, this does not mean all employees are limited to this cap. Some are exempted based on “catch-up” contributions. Two categories of employees can contribute more than $22,500.
As the name suggests, a non qualified annuity does not qualify for income taxes.
What are the similarities and differences between life insurance and annuity?
Employees above 50 years are first in this category. If an employee starts to pay their annuity contribution at 50 years, they are somewhat late. When this employee is eligible to activate earning distribution, their earnings may be meagre.
To help an employee who is 50+ years contribute as much to their annuity within a short period, they are allowed to contribute $7,500 more. This caps their contribution to $30,000 annually in 2023.
The second category of employees who qualify for a higher cap than $22,500 are those with 15 years still in service. Such an employee can contribute $3,000 more on top of the $22,500 limit.
Why Is There a Contribution Limit of Tax Deferred Annuities?
The primary goal protected by the government for contributing towards annuities is to save for retirement. This is why things like the age 59 ½ rule and cap limit for the qualified limit exist.
You would ask, doesn’t the government want me to save as much as I can for my retirement?
Well, the government is not against you saving as much as possible for your requirements. However, the government also want to protect its interest in cash flow. Remember, a government is just like a business entity. It needs cash flow for smooth operations of its activities.
If you contribute almost every penny of your salary into an annuity plan for a deferred tax, this will limit the ability of the government to collect income tax. Now assume everyone employed contributes more than 80% of their annual salary to the annuity.
This, on a nationwide basis, would translate into deferred revenue for the taxman. Since the taxman wants to hit their target of tax collection, they must limit how much you can contribute towards an annuity. This is to ensure you receive a substantial salary that will be taxed and help the taxman meet the target.
You can opt for a non-qualified annuity if you want to contribute as much as possible. This is an annuity funded by after-tax dollars. This means, ideally, you have optimally contributed to tax collection. This explains why a deduction from a non-qualified annuity is free from income tax.