What a Tax-Sheltered Annuity Is and How It Works

A tax-sheltered annuity lets you set aside money from your paycheck before taxes are taken out

A tax-sheltered annuity (TSA), also called a 403(b) plan, is a retirement savings account offered by schools, hospitals, nonprofits, and some government employers. Money goes in directly from your paycheck before federal income tax is calculated, which lowers your taxable income for that year. The money then grows without being taxed each year until you withdraw it in retirement.

The main appeal is the tax break now: if you earn $50,000 and contribute $5,000 to a TSA, you only pay income tax on $45,000. That's different from a regular savings account, where you'd pay tax on the full $50,000 and then save what's left. The tradeoff is that you cannot touch the money penalty-free until age 59½, with narrow exceptions.

TSAs are common in education and healthcare because these employers often do not offer 401(k) plans. If your employer offers one, you'll see it listed on your benefits paperwork or in your payroll system.

Key Takeaways

• A TSA reduces your taxable income in the year you contribute, which can lower your tax bill.
• Your employer must offer a TSA for you to open one — you cannot set one up on your own.
• Money in a TSA grows tax-free until you withdraw it, usually in retirement.
• You can contribute up to $23,500 per year (as of 2024), or more if you have 15+ years of service at your employer.
• Withdrawing money before age 59½ usually triggers a 10% penalty plus income tax on the amount withdrawn.

How contributions and tax savings work

When you enroll in your employer's TSA plan, you choose a percentage of your paycheck to contribute — say 5% or 10%. That amount is deducted before your employer calculates federal income tax. So if you earn $3,000 per paycheck and contribute $300 to your TSA, your taxable income for that paycheck is $2,700, not $3,000.

At tax time, you report a lower gross income to the IRS because the TSA contributions are already excluded. This means you owe less federal income tax that year. The exact savings depends on your tax bracket — someone in the 22% bracket saves $22 in federal tax for every $100 contributed, while someone in the 12% bracket saves $12.

State income tax treatment varies. Some states also exclude TSA contributions from state taxable income, while others do not. Check your state's tax rules or ask your employer's payroll department which applies to you.

Investment options and how your money grows

When you contribute to a TSA, the money goes into an investment account. Your employer typically offers a menu of investment choices — often mutual funds, target-date funds, or stable value funds. You choose where your money is invested, and those investments grow over time.

Unlike a savings account that earns a fixed interest rate, a TSA's growth depends on how the underlying investments perform. A fund that holds stocks might grow faster but fluctuate more. A stable value fund might grow slower but with less volatility. You can usually change your investment choices once or twice per year, or when your life circumstances change.

The key tax advantage is that you do not pay tax on the growth each year. If a mutual fund in your TSA earns $500 in gains, you do not owe tax on that $500 until you withdraw money from the account. In a regular taxable account, you would owe tax on those gains annually.

Contribution limits and catch-up rules

The IRS sets an annual limit on how much you can contribute to a TSA. For 2024, the limit is $23,500 per year. This is the same limit that applies to 401(k) plans. If you have multiple employers offering TSAs, your combined contributions across all of them cannot exceed this limit.

If you have worked at your current employer for 15 or more years, you may be able to contribute an additional $3,000 per year under a "catch-up" rule, up to a lifetime maximum of $15,000 in extra contributions. This rule is specific to TSAs and does not explore to 401(k) plans. Your employer's benefits office can tell you whether you may have access to and how to request it.

After age 50, you can also make "age 50 catch-up" contributions of an additional $7,500 per year, the same as with 401(k) plans. These two catch-up rules can sometimes stack, but the details depend on your employer's plan document.

Withdrawals, penalties, and what happens in retirement

You can withdraw money from your TSA anytime, but there is a cost if you are under age 59½. The withdrawal is subject to a 10% early withdrawal penalty plus regular income tax on the amount withdrawn. So if you withdraw $10,000 at age 45, you owe $1,000 in penalty plus income tax on the full $10,000 at your current tax rate.

A few situations allow you to withdraw without the 10% penalty: if you are permanently disabled, if you have unreimbursed medical expenses above a certain threshold, if you are a reservist called to active duty, or if you are separated from service and meet other conditions. These exceptions are narrow, and the rules are complex — check with a tax professional or your plan administrator before assuming you may have access to.

At age 59½, you can withdraw money without the 10% penalty, though you still owe income tax. At age 73, you must begin taking required minimum distributions (RMDs) — the IRS requires you to withdraw a certain amount each year based on your age and account balance. If you do not take the RMD, you owe a 25% penalty on the amount you should have withdrawn (reduced to 10% if you correct it within two years).

TSA versus other retirement plans

If your employer offers both a TSA and a 401(k), the main difference is the investment options and fees. A 401(k) typically offers a wider range of investments and may have lower fees because employers shop for better rates. A TSA may have higher fees because the insurance companies that administer them take a cut. However, some TSAs have competitive fees, so compare your plan's options.

If you work for a nonprofit or school and your employer does not offer a TSA, you might be able to open a SEP IRA or Solo 401(k) if you have self-employment income. These are separate accounts with their own rules and limits. A regular IRA is always an option, but contributions are not deducted from your paycheck, so you get the tax break at tax time rather than when ready.

A TSA is similar to a 401(k) in that both reduce your current taxable income and grow tax-free. The main practical difference is that TSAs are only available through certain employers, while 401(k)s are more common in the private sector.

How to enroll and manage your account

To open a TSA, contact your employer's human resources or benefits department and ask for the enrollment materials. You will fill out a form choosing your contribution amount and your investment selections. The contribution amount is usually a percentage of your paycheck, and you can change it once or twice per year or when your life circumstances change (marriage, birth of a child, job change).

After you enroll, your contributions are deducted automatically from each paycheck. You can log into your account online to see your balance, review your investment performance, and change your investment selections if needed. Your plan administrator sends you an annual statement showing contributions, growth, and current balance.

If you change jobs, you can leave the money in your TSA, roll it into your new employer's plan if they offer one, or roll it into an IRA. Rolling it over keeps the tax-deferred status intact. If you straightforward withdraw the money, you owe the 10% penalty (if under 59½) plus income tax.

Frequently Asked Questions

Can I withdraw money from my TSA if I need it before retirement?

You can withdraw money anytime, but if you are under age 59½, you will owe a 10% penalty plus income tax on the amount withdrawn. A few narrow exceptions exist — permanent disability, unreimbursed medical expenses, and a few others — but most people cannot avoid the penalty. Check with your plan administrator or a tax professional about your specific situation.

What happens to my TSA if I leave my job?

Your money stays in the account and continues to grow tax-free. You can leave it there, roll it into your new employer's TSA or 401(k) if they offer one, or roll it into an IRA. If you straightforward withdraw the money, you owe the 10% penalty (if under 59½) plus income tax. Rolling it over is usually the best option because it preserves the tax-deferred status.

Is a TSA the same as a 403(b)?

Yes. TSA and 403(b) are the same thing — the terms are used interchangeably. The name comes from the section of the tax code that governs the plan. You might see either term on your employer's benefits materials.

Can my employer match my TSA contributions?

Some employers do, but it is not common. Many schools and nonprofits do not offer matching contributions because of budget constraints. Check your plan documents or ask your benefits office whether your employer matches TSA contributions.

Do I pay taxes on my TSA contributions when I retire?

Yes. When you withdraw money in retirement, you owe income tax on the full amount withdrawn, including both your contributions and the growth. This is why a TSA is called "tax-deferred" rather than "tax-free" — you pay the tax later instead of now. The hope is that you will be in a lower tax bracket in retirement, so the total tax bill is smaller.