What Is a Tax-Sheltered Annuity (403(b) Plan)?

A tax-sheltered annuity, or 403(b) plan, is a retirement savings vehicle. It allows eligible employees to save for retirement with tax advantages. Participants contribute a portion of their income, and these contributions, along with investment earnings, grow on a tax-deferred basis until retirement.

Defining Tax-Sheltered Annuities

A 403(b) plan is a retirement savings program for employees of public schools, certain tax-exempt organizations, and eligible ministers. Employers offering these plans include public education institutions, state colleges, universities, and organizations classified under Internal Revenue Code Section 501(c)(3), such as charities and hospitals.

A 403(b) plan’s fundamental characteristic is its tax-deferred growth, meaning contributions and earnings are not taxed until withdrawn in retirement. The name “tax-sheltered annuity” comes from the historical primary offering of annuity contracts as investment options.

While “annuity” is part of its traditional name, a 403(b) plan is the retirement plan itself, not solely an annuity product. These plans operate similarly to 401(k) plans, allowing employees to save through payroll deductions.

Contribution Rules and Investment Options

Individuals contribute to a 403(b) plan through elective deferrals. Pre-tax contributions reduce current taxable income. Alternatively, some plans offer a Roth 403(b) option, where after-tax contributions lead to tax-free qualified withdrawals in retirement.

The Internal Revenue Service sets annual contribution limits for 403(b) plans. For 2025, the standard employee elective deferral limit is $23,500. Employees aged 50 and over can make additional “catch-up” contributions of $7,500, totaling $31,000. A provision under the SECURE 2.0 Act allows those aged 60 to 63 to contribute an even higher catch-up amount of $11,250.

Long-serving employees may qualify for a special 15-year catch-up contribution. This allows an additional $3,000 per year, up to a lifetime maximum of $15,000, for those with at least 15 years of service with the same eligible employer. The combined total of employee and employer contributions for 2025 is capped at $70,000, or 100% of the employee’s salary, whichever is less.

Investment options within 403(b) plans include annuity contracts and mutual funds. Annuity contracts, offered by insurance companies, can provide a guaranteed income stream in retirement. Mutual funds offer diversification across various securities. The specific investment choices depend on the employer’s plan design and selected vendors.

Withdrawal Rules and Taxation

Funds in a traditional 403(b) account are taxed as ordinary income upon withdrawal. Penalty-free withdrawals can begin once the account holder reaches age 59½. Withdrawals before this age incur a 10% early withdrawal penalty, plus regular income tax.

Exceptions to this penalty include separation from service at or after age 55, total and permanent disability, or distributions to beneficiaries after the account holder’s death. Other exceptions may cover unreimbursed medical expenses or payments under a Qualified Domestic Relations Order (QDRO).

Required Minimum Distributions (RMDs) mandate that account holders begin withdrawing funds from traditional 403(b) accounts once they reach a certain age. For most individuals, RMDs start at age 73. These distributions ensure taxes on deferred income are eventually paid. Failure to take the full RMD can result in a penalty of 25% of the amount not withdrawn, potentially reduced to 10% if corrected promptly.

For Roth 403(b) accounts, qualified distributions are entirely tax-free, provided two conditions are met: the account must be at least five years old, and the distribution must occur after age 59½, due to disability, or upon death. The SECURE 2.0 Act eliminated RMDs for Roth employer plans during the original owner’s lifetime.

Considering a Tax-Sheltered Annuity

When evaluating participation in a tax-sheltered annuity, understanding any employer contributions or matching programs is an important consideration. Some employers may contribute a fixed amount or match a percentage of employee contributions, which can significantly boost overall retirement savings.

A thorough review of the plan’s fees and available investment choices is also advisable. Fees can vary among different 403(b) plans and can impact the net returns on investments over time. Participants should examine the range of investment options, such as annuities and mutual funds, to determine if they align with their risk tolerance and financial goals. The performance history of the available investment options should also be a factor in decision-making.

Ultimately, deciding whether to participate in a 403(b) plan involves assessing how it integrates with an individual’s broader financial planning and retirement objectives. The tax advantages, contribution limits, and potential for employer contributions make it a valuable tool for long-term savings.