Drakula & Co. / Getty Images Taxpayers can also purchase government bonds, which aren’t savings accounts but work in a similar way. The sale of these bonds raises typically money for municipal and state governments. The interest they earn is often tax-exempt. However, some states won’t exempt interest earned on bonds issued by other states.
An Example of Tax-Free Savings Accounts
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 for qualifying medical expenses, you won’t pay taxes on your interest earnings. Or you might contribute after-tax dollars to a Roth individual retirement account (IRA), but your eventual withdrawals—including the interest earned over the years—will be tax-free.
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.
Traditional IRAs
Contributions to a 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. You’ll eventually pay income tax on the money, including your earnings, when you withdraw it in retirement.
Roth IRAs
You won’t get a tax break when you contribute to a Roth IRA, but your withdrawals in retirement are tax-free. Your earnings are also tax-free, subject to certain rules. Generally speaking, you have to:
Hold the account for a minimum of five years.You must Bebe at least age 59½ or have a disability 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Savings contributed to this type of account can be withdrawn for elementary, secondary, or post-secondary education costs, but there’s a catch: You must name the student who’s eventually going to benefit from this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 for any purpose other than the designated beneficiary’s education, although you can redirect the money to another child’s education if that child is, in most cases, under 30. 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 2022 tax year.
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 claim a tax deduction for money you put into this type of account, even if you don’t itemize on your return. Also, the IRS won’t tax contributions made by your employer. Interest earned on your deposits is tax-free, but you can only use the money for qualifying medical expenses. If you have Medicare coverage, you can’t make contributions to your HSA.
Flexible Spending Arrangements
A flexible spending account (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 use your FSA savings for 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.
Archer Medical Savings Accounts
This type of medical savings account (MSA) is also for paying qualifying health expenses. The money you save is tax-deductible (even if you don’t itemize), and there is no tax on the interest you earn and distributions used for qualified medical expenses. 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,” and you’re on a high-deductible health plan.
Do I Ever Need to Pay Taxes on This Money?
Tax-free and tax-advantaged savings options can be complicated because they have varying rules. Sometimes you can avoid being taxed on your contributions or your earnings, and sometimes on both. However, under some circumstances, you’ll owe taxes—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. You also can’t claim an itemized tax deduction for medical expenses that were reimbursed by an FSA. You’ll pay income tax and may have to pay a 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. 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.
