Chapter 5 — Tax Sheltered Annuities (TSAs)

The privilege of establishing a Tax Sheltered Annuity (TSA) plan is reserved for a selected group of employers and employees: certain nonprofit organizations and public educational institutions such as school districts, colleges, and universities. While the two most prominent markets are teachers and medical/hospital personnel, the eligible universe is large — and as the role of nonprofit service continues to expand, the number of eligible employees grows with it.

By adding the TSA provisions to the tax code, Congress created a special retirement plan for a special group. Recognizing that taxes, inflation, and the cost of living make adequate retirement savings difficult for many workers, Congress zeroed in on this selected group of employers and provided a tax-advantaged solution. Beyond the tax benefits, TSAs cement employer-employee relationships and help attract and retain high-caliber employees in a sector where compensation often lags the private market.

Congress created tax-sheltered annuities to encourage retirement savings among employees of nonprofit and public educational organizations. Originally, contributions to a TSA could only be used to purchase an annuity contract from a life insurance company. Over time, Congress expanded the permissible investments to include mutual fund accounts held in custodial arrangements.

These plans are known by several names, all referring to the same type of arrangement:

The Tax Reform Act of 1961 laid the foundation for the modern TSA program, though it was just the beginning of a series of legislative reforms that shaped the current rules. Regardless of what they are called, TSAs remain a popular and effective retirement planning vehicle — their success summarized simply: they cost less and they produce more.

TSA plans may only be established by:

• Tax-exempt organizations described under IRC §501(c)(3) — including hospitals, charities, religious organizations, private nonprofit schools and universities, and other qualifying nonprofits, and
• Public educational institutions — including public school districts (K–12), community colleges, state universities, and other governmental educational entities.

Private for-profit employers are not eligible to establish TSA plans. Employees of ineligible employers must use other retirement vehicles such as 401(k) plans, IRAs, or SEPs.

The two largest and most accessible TSA markets are:

• Teachers and school administrators employed by public school systems, community colleges, and state universities, and
• Medical and hospital personnel employed by nonprofit hospitals, health systems, and healthcare organizations.

The eligible market also includes employees of religious organizations, social service nonprofits, research institutions, private foundations, and many other §501(c)(3) entities. Many eligible employees come from two-income households with a higher-than-average propensity to save — making them receptive prospects for TSA planning.

To provide incentive and encourage retirement savings, Congress built significant tax advantages into TSAs. As with other qualified plans:

• contributions to a TSA are excluded from the employee’s gross income in the year contributed,
• earnings in the TSA accumulate tax-deferred — no annual income tax on dividends, interest, or capital gains while inside the plan, and
• savings are taxed as ordinary income when withdrawn at retirement.

Because TSAs are funded primarily through employee salary reduction, the employee’s W-2 wages are reduced by the amount deferred, reducing current federal (and usually state) income tax. The employee effectively invests pre-tax dollars that compound tax-deferred until distribution.

A TSA is structured as a long-term retirement savings program. Employees should make consistent contributions over a long period — ideally until retirement. The law actively discourages short-term use:

• Premature withdrawals before age 59½ are generally subject to a 10% early withdrawal penalty in addition to ordinary income tax.
• Required minimum distributions (RMDs) must begin at age 73 (or age 75 for those born after December 31, 1959, beginning in 2033) — the same thresholds that apply to traditional IRAs and 401(k) plans under SECURE Act 2.0.

Beyond the income tax advantages, TSAs offer several practical benefits that make them attractive to both employers and employees:

• Attract high-caliber employees: Competitive benefits are essential for recruiting in the nonprofit and public education sectors where cash compensation is often lower than comparable private-sector roles.
• Retain skilled employees: A strong retirement benefit reduces turnover and reinforces long-term employment relationships.
• No employer contributions required: In the vast majority of TSA plans, the employer does not contribute — the employer merely adopts the plan and administers it for employees. This delivers a meaningful employee benefit at minimal employer cost.
• No investment responsibility: Because the funding vehicle is an annuity or mutual fund custodial account selected by (or for) the employee, the employer is generally relieved of fiduciary responsibility for investment performance.

• Supplement to Social Security: TSA distributions provide retirement income beyond what Social Security alone can offer.
• Flexibility in timing: The maturity date of a TSA can be structured to coincide with a planned retirement date — including early retirement at age 55 under certain circumstances — or to align with Social Security benefit commencement.
• Investment choice: Modern TSA plans offer a range of investment options including fixed annuities (guaranteed interest), variable annuities (investment-linked), and mutual fund accounts.