What Is a Tax-Sheltered Annuity?

A Tax-Sheltered Annuity (TSA), commonly known as a 403(b) plan, serves as a retirement savings vehicle for employees of specific organizations. These plans allow individuals to save for retirement with considerable tax advantages, similar to a 401(k) plan but tailored for a different segment of the workforce. The primary purpose of a 403(b) is to help eligible employees accumulate retirement savings through tax-deferred growth.

Understanding Tax-Sheltered Annuities

A Tax-Sheltered Annuity (TSA), or 403(b) plan, is a retirement plan specifically designed for employees of public schools, certain tax-exempt organizations, and ministers. Tax-exempt organizations eligible to offer 403(b) plans are typically those classified under Internal Revenue Code Section 501(c)(3), such as hospitals, charities, and religious organizations. This structure distinguishes it from a 401(k) plan, which is generally offered by for-profit entities.

The fundamental “tax-sheltered” characteristic means that contributions made to the plan, along with any investment earnings, are not taxed until they are withdrawn in retirement. This allows the money to grow without annual taxation. Contributions are typically made through pre-tax payroll deductions, making it an employer-sponsored plan. The universal availability rule generally requires that if an employer offers a 403(b) to one employee, it must extend the offer to all employees within that organization, with limited exceptions.

Contributions and Growth

Contributions to a 403(b) plan are generally made as pre-tax payroll deductions, which reduces an employee’s current taxable income. For 2025, the standard elective deferral limit for employees is $23,500.

Beyond the standard limit, the IRS offers specific “catch-up” provisions to allow eligible individuals to save more. Employees aged 50 or older can contribute an additional $7,500 in 2025, increasing their personal contribution limit to $31,000. Furthermore, a special catch-up contribution exists for employees with 15 or more years of service with the same employer, allowing an additional $3,000 per year, up to a lifetime maximum of $15,000, provided certain conditions regarding past contributions are met. This 15-year rule can be utilized regardless of age, and if both catch-up opportunities are available, the 15-year catch-up is applied first.

The growth within a 403(b) account is tax-deferred, meaning investment earnings such as interest, dividends, and capital gains are not taxed until distributed. This allows the investments to compound over many years without the drag of annual taxation. While employers may also contribute to the plan, the total combined employee and employer contributions are subject to a separate limit, which is $70,000 for 2025.

Distributions and Withdrawals

When funds are withdrawn from a traditional 403(b) plan in retirement, all distributions, including both contributions and earnings, are generally taxed as ordinary income. However, if the plan includes a Roth 403(b) option, contributions are made after-tax, and qualified withdrawals in retirement are tax-free.

Withdrawals made before age 59½ are typically subject to a 10% early withdrawal penalty, in addition to being taxed as ordinary income. There are several common exceptions to this penalty, including separation from service in or after the year the employee turns age 55, total and permanent disability, death (distributions to beneficiaries), and distributions for unreimbursed medical expenses exceeding a certain percentage of adjusted gross income. Hardship withdrawals may also be permitted by the plan, but they must meet strict IRS criteria for an “immediate and heavy financial need.”

Required Minimum Distributions (RMDs) generally mandate that participants begin taking withdrawals from their traditional 403(b) accounts by April 1 of the year following the calendar year they reach age 73. Failing to take the required RMD can result in a significant penalty, which is typically 25% of the amount that should have been withdrawn. Subsequent RMDs must be taken by December 31 of each year.

Key Characteristics and Considerations

The investment products offered within a 403(b) plan are determined by the employer and typically include a mix of options. Common investment vehicles are annuity contracts provided through insurance companies and custodial accounts invested in mutual funds. Some plans may also offer a self-directed brokerage account, providing access to a wider array of investment choices.

The employer’s role in a 403(b) plan is primarily as a facilitator, setting up and administering the plan. While employers are not typically required to contribute, some may offer matching contributions, which can significantly boost an employee’s retirement savings. Employees should understand whether their employer provides such a match and aim to contribute enough to receive the full benefit.

Portability is an important feature of 403(b) plans; upon leaving employment, funds can generally be rolled over to another qualified retirement plan, such as a new employer’s 403(b) or 401(k), or to an Individual Retirement Account (IRA). It is also important for participants to understand the fees associated with their 403(b) plan, as these can vary significantly between providers and affect overall investment returns.