A tax-free savings account is a plan or savings vehicle into which you can deposit money without paying taxes on it, or one in which your money can grow and earn interest tax-free—as long as you follow certain rules. The Internal Revenue Code provides for a variety of tax-free savings options.
Each account has its own qualifying rules, however, and these rules can determine whether any of these plans are right for you.
Definition of Tax-Free Savings Accounts
The concept behind tax-free savings accounts and accounts that offer tax advantages is that the government wants people to save for purposes that are considered to be for the greater good, such as education, health expenses, and retirement.
For example, you might be able to claim a tax deduction for money you put into a health savings account (HSA), and if you use the money to pay qualifying medical expenses, you won’t pay taxes on your interest earnings. Or you might contribute after-tax dollars to a Roth Individual Retirement Arrangement (IRA), but your eventual withdrawals—including the interest earned over the years—are tax-free. Most of these accounts aren’t 100% “tax-free,” but they offer generous tax advantages as long as you follow the rules about eligibility, contributions, and withdrawals.
How Tax-Free Savings Accounts Work
Many of these accounts allow taxpayers to lower their taxable income. Contributions might be deducted from your paycheck before taxes are calculated on the balance, or you might claim a tax deduction for the amount on your tax return. Some of these savings plans require that you only take the money out of the account for qualifying purposes. For example, if you set up an HSA to save for medical expenses, you can’t use that money to fund a family vacation.
Many plans also offer the benefit that all the interest earned by your money while it was tucked aside is tax-free—as long as you use the funds for their assigned purpose. A tax-advantaged education account might allow you to withdraw the funds to pay for something other than education expenses, but you’ll pay taxes on the amount withdrawn, including the interest earned.
It’s been argued that high-income taxpayers benefit more from these types of savings plans because they’re in a higher tax bracket. A single individual who earns $210,000 would save 35% of each dollar earned in the highest tax bracket in 2021, while a single individual who earns only $30,000 would save just 12% of each dollar.
Taxpayers can also purchase government bonds, which aren’t savings accounts but work in a similar way. The sale of these bonds raises money for municipal and state governments, as well as for the federal government, and the interest they earn is often exempt from taxation. However, some states won’t exempt interest earned on bonds issued by other states.
Types of Tax-Free Savings Accounts
Various tax-advantaged savings plans exist, but most have strict qualifications and are designed to be used for specific types of expenses.
Contributions to a traditional Individual Retirement Arrangement (traditional IRA) are made with pre-tax dollars. You can claim a tax deduction for the money you save in an IRA up to a certain limit each year, and your savings will grow tax-free while they remain in the account. But you’ll eventually pay income tax on the money, including your earnings, when you withdraw it in retirement.
Contributions to and earnings in traditional 401(k) plans are tax-deferred until withdrawal, and withdrawals are taxable.
You won’t get a tax break when you contribute to a Roth IRA. But unlike with a traditional IRA, your withdrawals in retirement are tax-free, since you’ve already paid taxes on that money.
Your earnings are also tax-free, subject to certain rules:
- You must have held the account for a minimum of five years.
- You must be at least age 59½ or disabled when you take the withdrawals.
Even if you don’t meet the above criteria, you’re allowed to withdraw up to $10,000 tax-free to buy your first home, and for a few other scenarios.
Coverdell Savings Accounts
Savings contributed to this type of account can be withdrawn for elementary, secondary, or post-secondary education costs, but there’s a catch: You must name the student who’s eventually going to benefit from this account at the time you open it. You’ll have to pay a penalty if you end up using the money to pay for any purpose other than the designated beneficiary’s education, although you can redirect the money to another child.
These are after-tax contributions. You don’t get a tax deduction for money you save, but all earnings are tax-free as long as they don’t exceed the beneficiary’s education expenses. You’re limited to a total of $2,000 in contributions for the 2021 tax year.
Qualified tuition plans, more commonly known as 529 plans, work similarly. There’s no federal tax advantage for contributions, although earnings are tax-free as long as you use the proceeds for education purposes. These are state-based plans, so the rules for contributions can vary from state to state.
Health Savings Accounts
An HSA is a tax-free account where you can save for health care expenses if you maintain a high-deductible health plan. You can’t be enrolled in Medicare, and you can’t be claimed as a dependent on anyone else’s tax return. You can claim a tax deduction for money you put into this type of account even if you don’t itemize on your return, and you won’t be taxed on contributions made by your employer, either. Interest earned on your deposits is tax-free, but you can only use the money for qualifying medical expenses.
Flexible Spending Arrangements
A flexible spending arrangement (FSA) lets you save for medical and dental expenses through pre-tax deductions from your paychecks. Your employer can also make tax-free contributions on your behalf. When you incur health expenses, you’ll submit receipts and be reimbursed up to the amount you contributed. Since this is an employer-established savings plan, you don’t qualify if you’re self-employed.
Many FSAs don’t allow you to carry over funds from year to year. If you don’t use the money, you lose it. If your plan is one of them, make sure to spend the full balance so you don’t forfeit any of your savings.
Archer Medical Savings Accounts
This type of medical savings account (MSA) is also dedicated to paying qualifying health expenses. Like an HSA, the money you save isn’t taxed, nor is any interest earned. You can claim a tax deduction for your contributions without itemizing. Your employer can also make contributions on your behalf, and you won’t pay taxes on this money because it’s not treated as income.
You can qualify for an Archer MSA if you or your spouse are self-employed, or if either of you is employed by a company that meets the IRS definition of a “small employer.” You can’t be claimed as a dependent on anyone else’s tax return or be enrolled in Medicare.
Tax-Free Savings Accounts
The clearly named tax-free savings account (TFSA) is only available to people who pay taxes to Canada, and several qualifying rules apply. A TFSA allows you to save money in a plain, old savings account and eventually withdraw it without paying any tax on interest or capital gains. A TFSA can also hold investments, including mutual funds, securities, and bonds. If you qualify for a TFSA, you can contribute up to $6,000 in 2021, plus any unused contribution room from previous years.
This list is by no means all-inclusive. Other tax-advantaged savings options exist, including some offered by states.
Do I Ever Need To Pay Taxes on This Money?
Tax-free and tax-advantaged savings options can be complicated because there are many different types of accounts with varying rules. Sometimes you can avoid being taxed on your contributions, sometimes on your earnings, and sometimes on both. However, in some circumstances, a tax bill will come due—typically because you broke the qualifying rules.
For example, if your employer makes “excess” contributions to your Archer MSA, you’ll have to include the money on your tax return and pay taxes on it. You might also be charged a 6% excise tax on these contributions.
Likewise, you must include as income on your tax return any FSA contributions that were made by your employer to provide you with long-term care insurance. And you must personally elect to contribute a certain amount to this type of account each year. Your withdrawals are tax-free only up to this limit if you end up contributing more. Plus, you can’t claim an itemized tax deduction for medical expenses that were reimbursed by an FSA.
You’ll pay income tax as well as a 10% tax penalty on withdrawals from a Coverdell account if you use the money for anything other than qualifying education expenses. You’ll also owe a 10% tax penalty if you take money out of your IRA before you reach age 59½, although a few exceptions do apply—for example, you may withdraw up to $10,000 penalty-free to purchase your first home.
- State governments and the federal government exempt certain types of savings from taxation, but numerous rules apply, and they vary from one savings plan to the next.
- Tax-free accounts are generally designed to help you save for specific purposes, such as retirement, medical expenses, or your children’s education.
- Some of these accounts allow you to avoid paying taxes on the money you contribute, although you’ll pay taxes when you eventually withdraw the money.
- Many plans allow for tax-free growth, such as interest or capital gains earned on your contributions.
Before signing up for any of these accounts or plans, it’s a good idea to speak with a financial advisor or tax professional to make sure you understand all the rules and qualifications.