Tax-Sheltered Annuity

A tax-sheltered annuity, also called a 403(b) plan, is a retirement savings account available to employees of public schools, nonprofit organizations classified under Section 501(c)(3) of the Internal Revenue Code, and certain churches. Contributions reduce your taxable income in the year you make them, and investment earnings grow tax-deferred until you withdraw the funds in retirement. The IRS sets annual contribution limits that adjust each year for inflation.

Think of a tax-sheltered annuity as a 401(k) built specifically for teachers, hospital workers, and nonprofit staff rather than private company employees.

Who Qualifies to Use a 403(b) Plan

Your employer determines your eligibility. The 403(b) plan is available to you if your employer is one of the following:

• A public school or state college
• A tax-exempt 501(c)(3) nonprofit organization, such as a hospital, university, or charitable foundation
• A cooperative hospital service organization
• A self-employed minister or chaplain treated as an employee of a 501(c)(3) organization

Private for-profit employers cannot sponsor a 403(b) plan. Their employees use a 401(k) instead.

Contribution Limits for 2025

The IRS increased the 403(b) elective deferral limit to $23,500 for 2025, up from $23,000 in 2024. Total contributions, including both your deferrals and any employer contributions, cannot exceed $70,000 or 100% of your compensation, whichever is lower.

Additional catch-up contribution rules apply based on age:

• Age 50 or older: an extra $7,500 per year above the standard limit
• Ages 60 through 63: a special enhanced catch-up of the greater of $10,000 or 150% of the prior-year catch-up limit, beginning in 2025 under the SECURE 2.0 Act
• The 15-year rule: employees with 15 or more years of service at the same qualifying organization may contribute up to $3,000 more per year, up to a $15,000 lifetime maximum, if the plan allows it

How the Tax Deferral Works

Contributions to a traditional 403(b) come out of your paycheck before federal income tax is applied. Your employer reports the deferred amounts in Box 12 of your W-2 with Code E for pre-tax contributions. You do not report elective deferrals on your tax return, and you do not pay income tax on the invested amount or its earnings until you take distributions.

The tax benefit is most valuable when your retirement tax rate is lower than your working-years rate. If you expect the opposite, a Roth 403(b) option, where contributions are made after tax but qualified withdrawals are tax-free, may produce a better outcome.

Investment Options Inside a 403(b)

A 403(b) plan can hold three types of investments, depending on what your plan's terms allow.

• Annuity contracts: Insurance company products offering fixed, variable, or equity-indexed growth, where the interest mechanism follows from the annuity type selected
• Custodial accounts: Accounts invested in mutual funds, similar in structure to a 401(k) brokerage window
• Retirement income accounts: Available only to church employees, these accounts can hold either annuities or mutual funds

The quality of options varies widely by employer. Some 403(b) plans, particularly at smaller nonprofits, offer only high-fee variable annuities. If your plan offers this, contribute enough to capture any employer match and consider a Roth IRA for additional savings with lower-cost funds.

Early Withdrawal Rules

Withdrawals before age 59½ are subject to ordinary income tax plus a 10% early withdrawal penalty in most cases. The penalty does not apply to distributions made upon separation from service after age 55, distributions to a beneficiary after the account holder's death, or distributions to a totally and permanently disabled participant.

Beginning with distributions made after December 31, 2023, the SECURE 2.0 Act created a new exception for emergency personal expense distributions. These distributions avoid the 10% penalty but remain subject to ordinary income tax.

Required Minimum Distributions

You must start taking required minimum distributions from your 403(b) by April 1 of the year after you turn 73, under rules set by the SECURE 2.0 Act of 2022. The distribution amount is calculated each year by dividing the account balance by an IRS life expectancy factor. Failing to take an RMD triggers a 25% excise tax on the amount not withdrawn, which can be reduced to 10% if corrected within two years.

Rolling Over a 403(b)

You can roll your 403(b) into a traditional IRA, another 403(b), a 401(k), or a 457(b) plan when you leave your employer or reach age 59½. The rollover must be completed within 60 days if you take a distribution rather than requesting a direct transfer. A direct trustee-to-trustee transfer avoids the 20% mandatory withholding that applies when funds pass through your hands.

Sources

• https://www.irs.gov/publications/p571
• https://www.irs.gov/retirement-plans/irc-403b-tax-sheltered-annuity-plans
• https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-403b-tax-sheltered-annuity-plans
• https://smartasset.com/retirement/what-is-a-403b
• https://kahnlitwin.com/blogs/tax-blog/retirement-contribution-limits-key-insights-for-high-earners-with-403b-plans-and-side-businesses-in-2025