You can purchase non-qualified annuities with after-tax dollars. When your annuity matures and you start to receive distributions, you’re only taxed on the interest earnings because you’ve already paid taxes on your principal contribution. 

A tax-sheltered annuity (TSA) works differently. With a TSA, your employer deducts money from your paycheck before taxes and deposits it into the annuity. By avoiding taxes initially, you can potentially build your retirement income faster. 

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What’s a tax-sheltered annuity?

A TSA is a retirement plan purchased with pre-tax money that grows tax-deferred. These annuities are usually only available to tax-exempt organizations.

Here’s how a TSA compares to a non-qualifying annuity.

Eligibility

• TSA: Offered by public schools and specific charities.
• Non-qualifying annuity: Typically must be made available to every employee within the company, with limited exceptions such as employees who participate in a separate plan of the company or who work only a certain number of hours

Taxing contributions

• TSA: You make contributions with pre-tax dollars, which lowers your taxable income in the year you contribute. This tax deferral reduces your income tax each year you contribute. 
• Non-qualifying annuity: You usually purchase a non-qualified annuity with after-tax money. 

Taxing withdrawals

• TSA: Once you begin withdrawing money at retirement, the withdrawal is taxed as ordinary income. 
• Non-qualifying annuity: You are only taxed on the earnings because you’ve already paid taxes on your contribution when you begin making withdrawals during retirement.

It’s also important to note that annuity withdrawals before you reach age 59½ are typically subject to a 10% early withdrawal penalty tax. The entire distribution amount may be subject to a penalty for early withdrawals from a TSA. If you withdraw money early from a non-qualified annuity, typically only the withdrawn earnings and interest will be subject to the penalty.

Contribution limits

• TSA: The IRS caps the annual contributions for TSAs. Your limit will depend on your age and whether or not you qualify for catch-up contributions. 
• Non-qualifying annuity: No contribution limitations exist, but your annuity provider may impose limits.

Example of TSA vs. non-qualified annuity

Consider two individuals: Individual A and Individual B. Individual A qualifies for their employer’s TSA, while Individual B decides on a non-qualified fixed annuity. Both products have a 20-year term and a 5% fixed interest rate. 

• Individual A contributes $500/month pre-tax to a TSA.
• Individual B is subject to 12% federal tax rate and 6% state tax rate, so their contribution, after-tax, is $410/month.

At the end of the 20-year term, Individual A’s TSA value will be $205,517, while Individual B’s non-qualified annuity contract value will be $168,524 since the after-tax contributions are smaller. 

Benefits of tax-sheltered annuities

There are several advantages to opting for a tax-sheltered annuity.

Tax-deferred growth advantages

For many individuals, an attraction to a TSA is tax-deferred growth. A TSA can put more money toward retirement income while lowering the individual’s taxable income in any year contributions are made.

Potential employer contributions

For a TSA, the employer can match employee contributions. Some employers offer TSA matching, but they may provide certain limits on the matching contribution amount, such as 50% of every dollar the employee contributes. For 2025, the maximum combined contribution for an employee and employer in a TSA cannot exceed $70,000 or 100% of the includible compensation for the employee’s most recent year of service. Some individuals may qualify for catch-up contributions based on years of service or age, which can raise the maximum combined contribution further. 

Flexible contribution limits

For 2025, employees can contribute up to $23,500 if they’re under 50, or $31,000 if they’re age 50 or over (which includes both the base contribution limit and the special catch-up) and qualify for catch-up contributions. Individuals between the ages of 60 and 63 can make larger special catch-up contributions of up to $34,750 (which includes both the base contribution limit and the special catch-up).

Considerations and limitations of tax-sheltered annuities

While there are potential upsides to contributing to a TSA, there are also limiting factors to consider.

Contribution limits 

The IRS establishes limits on how much money you can contribute annually. If you’re over 50, these limits can increase by $7,500, or $11,250 if you’re 60 to 63. 

Potential penalties for early withdrawal

If you withdraw before the age of 59 ½, the withdrawal is subject to 10% IRS early withdrawal tax penalty and ordinary income taxes. In addition, your withdrawal may be subject to a surrender charge. You should carefully review the tax penalties. 

Fees and costs to watch

Some TSAs have high administrative costs and surrender fees that penalize you for early withdrawals. 

Required minimum distributions

Required minimum distributions (RMDs) begin at age 73 if you were born between 1951 and 1959. If you were born in 1960 or later, the RMD age increases to 75. Once you reach the applicable age, you must begin taking distributions or the IRS may impose a penalty of up to 25% of the amount you should have withdrawn. Your account balance and life expectancy determine the minimum distribution amount.

Should you contribute to a tax-sheltered annuity?

If you work for an organization that offers a TSA, contributing to it may be a great way to build your retirement assets. Your employer can deduct pre-tax contributions from your paycheck and may offer matching contributions. The pre-tax deductions can help reduce your income tax on the year of your contribution, and your contributions grow tax-deferred until you withdraw.

FAQ

How are contributions to a tax-sheltered annuity treated with regard to taxation?

Because you make pre-tax contributions, your taxable income is reduced in the years when you’re contributing to the TSA. When you begin taking withdrawals, the IRS considers your full withdrawal as taxable income.

This communication / article is for informational / educational purposes only.

It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation, please consult with your appropriate professional advisor.

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