What Is a Tax-Sheltered Annuity (TSA)?

A Tax-Sheltered Annuity (TSA) is a type of retirement savings plan available to employees of certain tax-exempt organizations, such as public schools, hospitals, and nonprofit entities. Also known as a 403(b) plan, it allows participants to contribute a portion of their salary on a pre-tax basis, meaning contributions are deducted from taxable income in the year they are made. This setup provides immediate tax savings while allowing investments to grow tax-deferred until funds are withdrawn, typically in retirement.

How a Tax-Sheltered Annuity Works

A TSA functions similarly to a 401(k) plan but is specifically designed for employees of eligible nonprofit and public-sector organizations. Participants defer a portion of their salary into the plan, often through automatic payroll deductions. These contributions can be invested in annuities, mutual funds, or other approved investment vehicles. The primary benefit is the ability to grow retirement savings in a tax-deferred manner, meaning taxes on earnings and contributions are postponed until withdrawals begin.

Employers may also contribute to a TSA, either by matching employee contributions or making discretionary contributions. However, not all employers provide matching contributions, and the availability of employer contributions depends on the specific plan.

Tax Advantages

One of the main benefits of a TSA is the tax treatment of contributions and earnings. Since contributions are made on a pre-tax basis, they reduce taxable income in the contribution year, potentially lowering the employee’s overall tax liability. The money within the TSA grows tax-deferred, meaning no taxes are owed on investment gains, interest, or dividends until distributions are taken.

When funds are withdrawn in retirement, they are taxed as ordinary income. This structure is beneficial for many retirees who may find themselves in a lower tax bracket compared to their working years. However, withdrawals made before age 59½ may be subject to a 10% early withdrawal penalty, unless an exception applies, such as disability, financial hardship, or separation from service after age 55.

Contribution Limits

The IRS sets annual contribution limits for TSAs, similar to other tax-advantaged retirement plans. For 2025, the contribution limit for employees is $23,500. Those aged 50 and older can contribute an additional $7,500 in catch-up contributions, bringing their total limit to $31,000. Some long-term employees (with at least 15 years of service with the same employer) may be eligible for an additional catch-up provision, allowing them to contribute even more, subject to certain conditions.

Employers can also make contributions on behalf of employees, but the total combined contributions (both employee and employer) cannot exceed the lesser of $70,000 (for 2025) or 100% of the employee’s compensation. These limits are adjusted annually for inflation.

Investment Options

Unlike 401(k) plans, which often offer a broad range of mutual funds and other securities, TSAs were originally designed primarily for annuity investments. Many plans still emphasize annuity contracts, including fixed, variable, and indexed annuities. However, TSAs now commonly include mutual fund investment options, particularly when offered through a 403(b)(7) custodial account, which holds mutual funds instead of annuities.

• Fixed Annuities provide a guaranteed rate of return, making them a stable investment choice.
• Variable Annuities allow investments in different sub-accounts, similar to mutual funds, with returns fluctuating based on market performance.
• Mutual Funds within a TSA allow participants to invest in diversified portfolios, often including equity and bond funds.

The specific investment options available depend on the employer’s plan and the financial institutions managing the TSA.

Withdrawals and Required Minimum Distributions (RMDs)

Withdrawals from a TSA are taxed as ordinary income. If taken before age 59½, they may be subject to an additional 10% early withdrawal penalty, unless an exception applies.

Like other tax-deferred retirement accounts, TSAs are subject to Required Minimum Distributions (RMDs), which mandate that account holders begin withdrawing funds starting at age 73 (or 75 for those born in 1960 or later). Failure to take RMDs results in substantial penalties — typically 50% of the amount that should have been withdrawn.

Differences Between TSAs and Other Retirement Plans

TSAs are often compared to 401(k) plans, but there are some key differences. While both plans offer tax-deferred growth, employer-sponsored contributions, and similar withdrawal rules, 401(k) plans are available to private-sector employees, while TSAs are limited to public schools, religious organizations, and certain nonprofits.

Another distinction is that TSAs historically focused on annuity contracts, though many now offer mutual funds. In contrast, 401(k) plans typically provide a broader range of investment choices, including stocks, bonds, and ETFs.

TSAs also differ from 457(b) plans, which are another type of retirement plan available to government and nonprofit employees. While both plans allow tax-deferred contributions, 457(b) plans do not impose early withdrawal penalties for distributions made before age 59½ if the participant separates from service. TSAs, however, generally follow the same penalty rules as 401(k) plans.

Potential Downsides

Despite their advantages, TSAs have some drawbacks. One concern is the prevalence of annuity products, which can come with high fees and surrender charges. Some TSA annuities have complex fee structures, making it difficult for participants to assess their true costs.

Limited investment choices can also be a drawback. While some plans offer mutual funds, others restrict options to annuity products, which may not align with an investor’s preference for a more diversified portfolio.

Another potential issue is the lack of employer matching contributions in some TSA plans. While 401(k) plans often include employer-matching contributions, TSA participants may not always receive the same benefit, depending on the employer’s policy.

The Bottom Line

A Tax-Sheltered Annuity (TSA) is a powerful retirement savings tool for employees of qualifying nonprofit and public-sector organizations. By allowing tax-deferred contributions and investment growth, it provides an effective way to build wealth for retirement. However, participants should carefully consider their investment options, fees, and potential employer contributions when utilizing a TSA. Understanding the tax implications, withdrawal rules, and contribution limits can help maximize the benefits of this retirement savings plan while avoiding common pitfalls.