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What are the Different Types of Tax-Deductible Savings Accounts?

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  • Written By: John Lister
  • Edited By: Kristen Osborne
  • Last Modified Date: 10 September 2016
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The most popular forms of tax-deductible savings accounts are the IRA and the Roth IRA. These work in different ways, with the tax deduction applying to contributions in the former case and withdrawals in the latter case. There is also a special savings plan for higher education expenses that offers a variety of tax benefits.

One popular form of tax-deductible savings account is the IRA or individual retirement account. In the original form, known as a traditional IRA, contributions are tax deductible. This means that a person earning $40,000 US Dollars (USD) who pays $2,000 USD into an IRA will pay income tax for the year as if he earned $38,000 USD. The person does not pay tax on the fund until he retires and begins making withdrawals. This money is then classed as part of his income for that year and is subject to income tax.

The contrasting type of tax-deductible savings is known as the Roth IRA, named after the politician who sponsored the legislation setting it up. It reverses the tax process, meaning the contributions to the fund are not tax deductible, but the withdrawals upon retirement are. This would normally be an advantage to somebody who is in a higher tax bracket upon making the withdrawals then when making the contributions.

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Another major difference between the two types of IRA is age restrictions. With a traditional IRA, there is a 10% penalty for withdrawing any money from the fund before the age of 59 and a half, save for some exceptions related to education, health, or home purchases expenses. A traditional IRA holder must also begin to withdraw some money from the fund upon turning 70 and a half, and must make a minimum withdrawal from the fund each year after that, based on a sliding scale formula. While there are still withdrawal restrictions on a Roth IRA in certain situations, they are less stringent than those associated with a traditional IRA. This can be a benefit if, for example, the person is not in need of the income at the age of 70 and a half, and would rather the money be given a longer chance to grow, tax-free.

Parents wanting to save money to help fund their child's university education can use a tax-deductible savings account known as a 529 plan, named after the relevant section of US tax law. Such plans have significant tax advantages. The person paying into the plan can deduct the payments from his taxable income for the year. The growth on the money in the plan from investments is not taxed. And the student usually does not pay tax upon receiving the money, as long as it is spent on approved college-related costs such as tuition fees, accommodation or equipment.

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