Tax Free Savings Account

A 401k or an IRA account is an example of a tax free savings account. Earnings accumulating in these accounts are not included in taxable income while you are saving for retirement.

The gains do not get reported to the IRS each year whereas even the interest from small savings accounts is shown each year on a 1099 statement to be included in your yearly tax filings.

This is just one example of the special tax treatment given to your retirement savings account.

Another benefit is that the income you send to this type of account is subtracted from your total taxable income which means you pay less income tax each year.

For example, if you put $100 per week in a savings account, you paid income taxes on that money.

But if you put $100 into a 401k, it was deducted before taxes were calculated, so your tax withheld is less, leaving you more free money.

Retirement Savings Contribution Credit

For some people, on top of these benefits, there is the Retirement Savings Contribution Credit. This tax credit is available to filers 18 and over, with taxable income up to $56,500 for married filing jointly (see http://www.irs.gov/taxtopics/tc610.html for more details.) The credit can be between 10 and 50% of the amount you saved in 401k and IRA accounts combined.

Image Source: Form 8880 at irs.gov

IRS tax credit chart

Free Money in Your Account

In addition to the tax free earnings in your 401k savings account, you may also be eligible for free money from your employer. Many companies offer a matching contribution for employees who participate in their 401k plan.

This could be something like for each dollar you save the company will contribute an additional fifty cents up to a maximum of 6 percent of your salary. Some companies may match dollar for dollar up to 6 percent, paid directly into your account.

This is free money that you should always take advantage of.

The actual "cost" to you of contributing to your retirement account is lower than the amount of your contribution. This is because your withholdings will be lower because of the contribution. For example, if you contribute $100 to your retirement account through your employer's 401k savings plan, your paycheck may only be reduced by $80. The difference varies depending on how much you make and how often you get paid, such as weekly, bi-weekly, or monthly.

Summary of benefits of a tax free savings account

  • No tax on interest or investment gains in retirement savings account
  • Lower income taxes each year reduced by savings amount
  • Retirement Savings Contribution Credit, for some taxpayers
  • For those with 401k savings, free money from employer
  • "Discount" on contribution amount from lower tax withholding
  • Best of all: putting money aside for retirement, some for free