How Tax-Deferred Annuities Work and What Happens to Your Money

A tax-deferred annuity lets you put money into an insurance contract where it grows without being taxed each year, and you pay taxes only when you withdraw

A tax-deferred annuity (often called a TDA or 403(b) annuity when offered through schools and nonprofits) is an insurance product where your contributions and the earnings they generate are not taxed annually. Instead, taxes are postponed until you take money out. This is different from a regular investment account, where you owe tax on dividends and capital gains each year even if you do not touch the money.

The trade-off is straightforward: you get years of tax-free growth inside the account, but when you eventually withdraw, those withdrawals are taxed as ordinary income. The IRS does not forgive the tax — it just delays it. This structure appeals to people who expect to be in a lower tax bracket after they retire, or who straightforward want to reduce their tax bill during their working years.

Key Takeaways

• Money in a tax-deferred annuity grows without annual tax bills, but withdrawals are taxed as ordinary income at your rate when you take them out.
• You must wait until age 59½ to withdraw without a 10 percent penalty, though some annuities have different rules if you are still working.
• Required minimum distributions begin at age 73, meaning you cannot keep the money in the account indefinitely.
• Tax-deferred annuities sold through employers (403(b) plans) have contribution limits set by the IRS each year, while individual annuities do not.
• The insurance company issuing the annuity guarantees a minimum return, but you bear the risk if you choose variable investment options.

How the tax deferral actually works

When you contribute to a tax-deferred annuity, that money does not reduce your taxable income for the year (unless it is through a 403(b) plan at work, which does). The growth — whether from interest, dividends, or investment gains — sits inside the annuity contract untouched by the IRS each year. You see no 1099 form, no tax bill on the earnings, and no need to report the growth on your tax return.

This compounds over time. If you put $10,000 into a tax-deferred annuity earning 5 percent annually, after 20 years you have roughly $26,500. In a regular taxable account earning the same 5 percent, you would owe tax on the earnings each year, which would reduce your balance. The longer the money sits, the more the tax deferral matters.

The catch arrives when you withdraw. If you pull out $26,500, the entire $16,500 gain is taxed as ordinary income in the year you withdraw it. If you are in the 22 percent tax bracket, that gain costs you about $3,630 in federal tax. The deferral did not eliminate the tax — it moved it to later.

Withdrawal rules and the 59½ age threshold

You can withdraw money from a tax-deferred annuity at any time, but the IRS charges a 10 percent early withdrawal penalty if you are under age 59½. This penalty applies on top of ordinary income tax. So if you withdraw $10,000 at age 45, you owe income tax on the full amount plus $1,000 in penalty.

Some annuities have exceptions. If you are still employed and your plan allows it, you may be able to withdraw without the penalty even before 59½. A few annuities also allow penalty-free withdrawals for specific hardships, though these are rare and the rules vary by contract. Always check your annuity's terms before assuming an exception applies.

At age 59½, the penalty disappears, but you still owe ordinary income tax on any withdrawals. You can take as much or as little as you want, whenever you want, with no penalty — though the IRS will require you to take a minimum amount each year once you reach age 73.

Required minimum distributions at age 73

The IRS does not let you keep money in a tax-deferred annuity indefinitely. Starting at age 73, you must withdraw a calculated minimum amount each year, whether you need the money or not. This amount is based on your age and the account balance, and the IRS publishes a table each year showing what you owe.

If you do not take the required minimum distribution, the IRS charges a penalty equal to 25 percent of the shortfall (reduced to 10 percent if you correct it within two years). This is one of the harshest penalties in the tax code, so it is important to track the important date each year. Your annuity provider will usually calculate and notify you of the amount due, but the responsibility to withdraw is yours.

Contribution limits for employer-sponsored plans

If your tax-deferred annuity is part of a 403(b) plan through your school, hospital, or nonprofit employer, the IRS sets an annual contribution limit. For 2024, that limit is $23,500 for workers under age 50, and $31,000 for workers age 50 and older (the extra $7,500 is called a catch-up contribution). These limits change each year and are announced by the IRS in November.

Individual tax-deferred annuities sold outside an employer plan have no IRS contribution limit — you can buy as much as you want. However, the insurance company may set its own minimums or maximums, and you cannot deduct the contributions from your taxes unless the annuity is part of a may have access to retirement plan.

If you have both a 403(b) annuity and a 401(k) through another employer, the contribution limits are separate. You can contribute the maximum to each plan in the same year.

Fixed versus variable annuities and the risk you carry

A fixed tax-deferred annuity guarantees a set interest rate for a period of time (often 3, 5, or 10 years). The insurance company bears the investment risk. Your money grows predictably, and you know exactly what you will have at the end of the may provide period. After the period ends, the rate resets, usually lower.

A variable tax-deferred annuity lets you choose how to invest the money — typically among mutual fund-like options inside the annuity. Your return depends on how those investments perform. If the stock market rises, your annuity rises. If it falls, your annuity falls. You carry the investment risk, not the insurance company. Variable annuities often charge higher fees than fixed ones because the insurance company is managing more complex investments.

Some annuities offer a hybrid: a fixed return on part of your money and variable options on the rest. The choice between fixed and variable depends on your comfort with market risk and your time horizon. Someone nearing retirement might prefer fixed; someone with 20 years until retirement might accept variable for higher growth potential.

Fees and what they cost you

Tax-deferred annuities charge fees that reduce your return. A fixed annuity might charge a small annual fee (often under 1 percent) or none at all. A variable annuity typically charges an annual fee (called a mortality and expense fee, or M&E fee) of 1 to 1.5 percent, plus the fees of the underlying mutual funds you choose, which can add another 0.5 to 2 percent or more.

Some annuities also charge surrender charges if you withdraw more than a certain amount in early years — typically 5 to 10 years after purchase. These charges can be 5 to 10 percent of the withdrawal amount. Always ask for a fee schedule before buying, and understand what you are paying for. Over decades, even small percentage differences compound significantly.

When a tax-deferred annuity makes sense

A tax-deferred annuity is most useful if you have already maxed out other retirement accounts like a 401(k) or IRA and want to save more. Teachers and nonprofit employees often use 403(b) annuities because they are offered through their employer and contributions reduce their taxable income when ready.

An individual tax-deferred annuity makes less sense for most people because contributions are not tax-deductible and fees are often high. However, if you have a large lump sum (from an inheritance or bonus) and want may provide growth with tax deferral, a fixed annuity might be worth considering. The key is comparing the fees and guarantees to other options like CDs or bonds.

Tax-deferred annuities are not a substitute for emergency savings or short-term goals. The 10 percent early withdrawal penalty and the commitment to leave money untouched for years make them suitable only for money you will not need before age 59½.

Frequently Asked Questions

Can I move money from a tax-deferred annuity to an IRA without paying tax?

Yes, if you do a direct transfer (also called a trustee-to-trustee transfer). The money moves from the annuity to the IRA without passing through your hands, so no tax is owed and no penalty applies. If you withdraw the money yourself and deposit it later, you have 60 days to complete a rollover, and if you miss the important date, the full amount is taxed and penalized. Always ask your annuity provider to do a direct transfer.

What happens to my tax-deferred annuity if I die?

The remaining balance passes to your beneficiary, who must then withdraw it according to IRS rules. If the beneficiary is a spouse, they can treat the annuity as their own and delay withdrawals. Non-spouse beneficiaries must generally withdraw the entire balance within 10 years. The withdrawals are taxed as ordinary income to the beneficiary. Check your annuity contract to confirm who is named as beneficiary.

Is the money in a tax-deferred annuity protected if the insurance company fails?

Each state has a guaranty fund that protects annuity holders if an insurance company becomes insolvent. The protection limit varies by state but is typically $100,000 to $250,000 per person per company. This is not FDIC insurance — it is a state-run safety net. Before buying an annuity, check your state's guaranty fund limits and verify the insurance company's financial rating through agencies like A.M. Best.

Can I take a loan against my tax-deferred annuity?

Some annuities allow loans, but many do not. If your annuity permits it, you can borrow against the balance, and the loan is not taxed or penalized. However, you must repay it with interest, and if you do not, the unpaid balance is treated as a withdrawal and taxed plus penalized. Loans are rare in annuities and come with strict terms — read your contract carefully before assuming this option is available.

Do I have to buy an annuity through my employer, or can I buy one on my own?

You can buy a tax-deferred annuity on your own from an insurance company or through a financial advisor. However, individual annuities are not tax-deductible, so your contributions do not reduce your taxable income. They make sense mainly if you have already maxed out 401(k)s and IRAs and want additional tax-deferred growth. Employer-sponsored annuities (like 403(b) plans) are usually better because contributions are deductible and employers often match a portion.