What Is a Tax-Sheltered Annuity and How Does It Work?
Discover how tax-sheltered annuities (403b plans) work. Understand their unique structure for retirement savings, from funding to distributions.
A tax-sheltered annuity offers a structured approach to saving for retirement, particularly for individuals employed by specific types of organizations. This retirement savings vehicle provides tax advantages designed to encourage long-term financial planning.
What is a Tax-Sheltered Annuity?
A tax-sheltered annuity, commonly known as a 403(b) plan, is a retirement savings program available to employees of public schools, certain tax-exempt organizations, and religious entities. It functions similarly to a 401(k) plan, but is designed for the unique employment landscape of these non-profit sectors. Organizations eligible to offer 403(b) plans include public educational institutions, such as K-12 schools, state colleges, and universities. Additionally, employees of charitable organizations recognized under Internal Revenue Code Section 501(c)(3), cooperative hospital service organizations, and certain ministers can participate.
The “tax-sheltered” aspect means that contributions and investment earnings within the plan are not taxed until they are withdrawn, typically during retirement. This tax deferral allows savings to grow over time without annual taxation on investment gains, fostering a larger retirement nest egg. While historically associated with annuities, 403(b) plans today can also offer investment options like mutual funds through custodial accounts. The specific investment products available within a 403(b) plan are determined by the employer or the plan provisions.
How Contributions and Investments Work
Funding a tax-sheltered annuity primarily involves pre-tax salary deferrals made by the employee, which are deducted directly from their paycheck. Employers may also contribute to the plan, either through matching contributions or discretionary contributions, further enhancing the employee’s retirement savings.
The Internal Revenue Service (IRS) sets annual limits on how much can be contributed to a 403(b) plan. For 2025, employees can generally contribute up to $23,500 in elective deferrals. For those aged 50 or older, an additional “catch-up” contribution of $7,500 is permitted, increasing their total elective deferral limit to $31,000. A new “super catch-up” provision for 2025 allows individuals aged 60 to 63 to contribute an additional $11,250, potentially reaching a total of $34,750, if their plan allows.
Beyond these age-based catch-up provisions, employees with at least 15 years of service with the same eligible employer may qualify for a special 403(b) catch-up contribution of up to $3,000 annually, subject to a $15,000 lifetime limit. The total contributions from both employee and employer to a 403(b) account are also capped. For 2025, this combined limit is generally $70,000, or $77,500 for those aged 50 or older. Investment growth within the plan, whether in annuities or mutual funds, continues to be tax-deferred, meaning no taxes are paid on earnings until withdrawal.
Understanding Distributions and Withdrawals
Withdrawals are generally permitted upon retirement, separation from service, or reaching age 59½. Any distributions from a traditional 403(b) plan are taxed as ordinary income in the year they are received, as both contributions and earnings were tax-deferred.
Early withdrawals made before age 59½ are typically subject to a 10% additional tax penalty, in addition to being taxed as ordinary income. However, certain exceptions can waive this penalty, such as separation from service at age 55 or later, disability, or specific unreimbursed medical expenses. Another exception includes taking substantially equal periodic payments (SEPPs) under IRS rules.
Participants in traditional 403(b) plans are generally required to begin taking Required Minimum Distributions (RMDs) once they reach age 73. These RMDs are calculated annually based on the account balance and the individual’s life expectancy, as determined by IRS tables. Failure to take the full RMD by the deadline can result in a significant penalty, typically 25% of the amount not withdrawn, though this can be reduced to 10% if corrected within two years. In contrast, qualified distributions from Roth 403(b) accounts are tax-free, and Roth accounts are not subject to RMDs during the original owner’s lifetime.