Tax-Sheltered Annuities: Purchase Decisions

Abstract

When an employee is given the opportunity to elect a tax-sheltered annuity contract in lieu of part of his regular compensation, he is faced with a number of decisions. Should he participate in the plan? If so, how much of his salary should he divert into the annuity? Where there is a choice, what insurer should he select to underwrite the contract and what kind of annuity contract should he elect? These decision areas are examined with the purpose of developing some meaningful guidelines for use in making what are by no means simple determinations. Employees of educational, charitable, and religious organizations are eligible for a unique Federal income tax benefit. Ordinarily, when an employee is given nonforfeitable rights in an annuity contract purchased for him by his employer, he must include as current income the premiums paid by his employer. But within limits, an employee of an educational, charitable, or religious organization is not required to report these premiums as current income. The proceeds of the annuity, when received, however, must be reported as gross income. The right of certain employees to exclude from current income employer-paid premiums for nonforfeitable annuity contracts is not new. Since 1942, the Internal Revenue Code has provided employees of certain organizations an income tax benefit for these annuities. However, prior Robert I. Mehr, Ph.D., is Professor of Finance in the University of Illinois. Dr. Mehr is President of the American Risk and Insurance Association, Chairman of the Executive Committee of the Pacific Insurance Conference, Chaplain and Founder of the Risk Theory Seminar, a former member of the Board of the American Finance Association, Past President of the American Society for Insurance Research, Founder and Chairman of the InterAmerican Insurance Forums, and a two-time winner of the Elizur Wright Award for outstanding original contribution to the literature of risk and insurance. This paper was submitted in October, 1967. to the Technical Amendments Act of 1958, hamstringing administrative decrees rendered these provisions ineffective. One of these restrictions prohibited employees from requesting reductions in cash salaries to provide funds for the purchase of annuities by employers. Another restriction limited the amount which could receive tax shelter to 10 per cent of the income received from such employers. Some tax authorities, including Congressman Mills, believed that the Revenue Service had exceeded its authority in issuing these regulations. Agitation for Congressional clarification resulted in the 1958 revision of the Code provisions for tax-sheltered annuities. Section 23 of the Technical Amendments Act of 1958 added Section 403(b) to the Internal Revenue Code of 1954 to dispel some of the doubts raised by the Regulations pertinent to Section 403(a), the predecessor of Sec-