What Is a Tax-Sheltered Annuity (TSA) Plan?

A Tax-Sheltered Annuity (TSA) plan is a retirement savings vehicle offering tax-deferred growth on investments. Earnings are not taxed until withdrawal, typically in retirement. This deferral helps savings grow more rapidly over time by allowing investment returns to compound without immediate tax reduction.

Defining a Tax-Sheltered Annuity Plan

A Tax-Sheltered Annuity plan is commonly known as a 403(b) plan, named after its governing section of the Internal Revenue Code. These plans are available to employees of public school systems, state colleges and universities, and certain tax-exempt organizations. This includes hospitals and organizations classified under IRS Section 501(c)(3), such as non-profit, charitable, or religious organizations. Ministers are also eligible.

A 403(b) plan has a tax-advantaged structure. Contributions are pre-tax, deducted from gross income before taxes, reducing current taxable income and providing immediate tax savings. Funds and their investment earnings grow tax-deferred, with taxes postponed until withdrawal, usually during retirement.

Unlike taxable investment accounts, a 403(b) permits earnings to accumulate without annual tax payments. This allows for greater long-term wealth accumulation.

Contributions and Investment Growth

Contributions to a Tax-Sheltered Annuity plan occur primarily through employee salary deferrals, where a portion of a paycheck is invested before taxes. Some plans also permit after-tax Roth 403(b) contributions or employer contributions, which can significantly boost retirement savings.

The IRS sets annual contribution limits for 403(b) plans. For 2024, the maximum elective deferral is $23,000, increasing to $23,500 in 2025. Employees aged 50 or older can make additional “catch-up” contributions of $7,500 for 2024 and 2025, raising their total possible contribution to $30,500 in 2024 and $31,000 in 2025.

A special “15-year rule” allows long-service employees to make additional catch-up contributions, up to $3,000 per year, with a lifetime limit of $15,000. Total combined employee and employer contributions cannot exceed $69,000 for 2024 and $70,000 for 2025, or 100% of includible compensation, whichever is less.

Funds within a TSA plan are invested in annuity contracts or mutual funds. Annuity contracts, offered through insurance companies, can provide a guaranteed income stream in retirement. Mutual funds offer diversification across various stocks, bonds, or other securities. Investment options are selected by the employer sponsoring the plan.

Accessing Funds and Taxation

Accessing funds from a Tax-Sheltered Annuity plan is intended for retirement, with specific rules governing withdrawals to maintain tax advantages. Distributions can be taken without an early withdrawal penalty upon reaching age 59½, separating from service, becoming disabled, or upon death. Individuals separating from service at age 55 or older may also access funds without the 10% early withdrawal penalty.

Withdrawals before age 59½, not covered by an exception, are subject to a 10% additional tax penalty, plus regular income tax. Exceptions include:
Total and permanent disability
Unreimbursed medical expenses exceeding 7.5% of adjusted gross income
Distributions as part of a series of substantially equal periodic payments (SEPP) under IRS Rule 72(t)
An IRS levy on the account
Payments under a Qualified Domestic Relations Order (QDRO)

Required Minimum Distributions (RMDs) begin once the account holder reaches age 73. These rules mandate annual withdrawals to ensure tax-deferred funds are eventually taxed. Failure to take the full RMD can result in a 25% penalty on the undistributed amount. If still employed by the plan-sponsoring employer, RMDs can be delayed until April 1st of the year following retirement.

Distributions from a traditional TSA plan are taxed as ordinary income, subject to federal and potentially state income tax rates. If the plan includes Roth contributions, qualified withdrawals from the Roth portion are tax-free. Funds can be rolled over into another qualified retirement plan, such as an Individual Retirement Account (IRA) or a new employer’s 401(k) or 403(b), to continue tax deferral. A direct rollover, where funds are transferred directly between custodians, is recommended to avoid potential tax withholding or penalties.

Establishing and Administering a TSA

Establishing a Tax-Sheltered Annuity plan requires the employer to adopt a written plan document that complies with IRS regulations. Employers must select plan providers, such as insurance companies offering annuity contracts or mutual fund custodians. The choice of providers determines the investment options available to employees.

Once established, employees enroll by making salary deferral elections, specifying the amount or percentage of pay they wish to contribute. This involves coordinating with the employer’s payroll department to ensure proper deductions and remittances to chosen investment providers. Employers maintain accurate records of contributions and distributions for all participants.

Employers are responsible for ensuring contributions are properly remitted to investment providers in a timely manner. They also have reporting requirements, including providing information to the IRS and plan participants. While 403(b) plans are not subject to all the same fiduciary rules as 401(k)s under ERISA, they still require diligent oversight to ensure compliance with tax laws and proper operation.