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Tax Exempt Savings Plans

written by: randalarias•edited by: Laurie Patsalides•updated: 4/27/2009

There are three types of tax exempt savings plans and all are designed to help you save money for the major expenses in life: college, retirement, and medical expenses. Learn what these savings plans are and how to take advantage of them.

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    Why Tax Exempt Savings Plans?

    There are three types of tax exempt savings plans: health savings accounts, retirement savings plans, and 529 savings plans for your child's education. These plans are very important because they allow you to save some of your income tax free, and sometimes even have it matched. These plans are designed to allow you to prepare for three of the largest expenses in your future: medical expenses, your child's college tuition, and your own retirement.

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    Health Savings Accounts

    Health Savings Accounts (HSAs) are tax exempt savings plans that help you manage the cost of your health care by paying for medical expenses and bills from the account. One of the best parts about HSAs are that they collect interest over time. All withdraws, contributions, and even interest is tax free, up to a fixed amount, as long as they're used for medical purposes.

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    How health savings accounts work

    If you want to start a health savings account you'll need to apply for a HSA qualified high deductible health plan (or HDHP). Next, you open your HSA at a bank or credit union. Then all you need to do is make contributions to your account, up to the preset annual maximum set by the government. If you make contributions as an employee, contributions are tax deductible on your next tax return. If you make the contributions as an employer, on the other hand, contributions are exempt from federal employement taxes. When you have medical expenses, such as hospital or doctor visits, you withdraw money from your HSA to cover the amount. If you ever decide to stop your HDHP coverage you will still have access to your health savings account funds for medical costs.

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    Downside to health savings accounts

    There is a downside to HSAs, however. If you use any of the funds for non-medical reasons you'll have to pay both income tax on the amount and a 10% penalty. This doesn't mean you should be afraid to start a health savings account, however. They're a great way to make sure you have money for any medical expenses that may come up for you and your dependents in the future and save you money because you don't have to pay income tax on contributions and withdraws.

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    529 Savings Plans529 savings plan can help you save for your children's future education. Find out how this savings plan works!
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    529 Savings Plans

    529 savings plans are designed to help you save for your children's education. These plans can direct your funds toward tuition at state universities, basically allowing you to buy future tuition credits at today's rate. The benefit of this is allowing your child to receive lower tuition costs. If you don't know which university your child plans to attend you can save the money in the 529 savings plan for a set amount of time and decide the school later. These options are referred to as prepaid 529s and savings 529s. 529 savings plans allow you to keep control of the account and, if you ever wish to, reclaim funds for yourself at a penalty.

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    How do 529 savings plans work?

    If you're interested in a 529 savings plan for your child you'll need to open the account with a bank or financial institution. When you open the account you'll get the option of automatic deposits or a fixed amount. No matter which option you decide on you can always make additional deposits by contacting the bank. Funds you withdraw from your 529 savings plan are tax free, making it a great way to save money while putting away money for your child to attend school. A downside to 529 savings plans is they count as an asset, which can affect a variety of things, including receiving financial aid.

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    Retirement Plans

    The most commonly used tax exempt savings plans are retirement plans. There are three types: 401(k)s, 403(b)s, and 457s. These plans are all supported by the IRS to help individuals save for their retirement while they work.

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    What's a 401(k)?

    The 401(k) is the most used retirement savings plan. It works by allowing an employee to deposit part of their paycheck or salary into their 401(k) plan. Employers match the employee's contribution by a certain amount, decided by the employer. The obvious benefit of a 401(k) is the employer's matched contribution, allowing you to save even more money for your retirement. Another benefit of 401(k)s is that you're allowed to borrow money from them, although you'll be given a 10% penalty. Still, this gives you access to money in case of a serious emergency.

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    What's a 403(b)?

    403(b)s are offered to employees of nonprofit organizations. The money contributed to a 403(b) is pretax, straight from a paycheck. Unlike 401(k)s, however, employers do not match or contribute any funds to an employee's 403(b).

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    What's a 457?

    A 457 is a tax exempt savings plan offered only to employees of state and local governments, as well as other tax exempt organizations like unions. Contributions made to a 457 are pretax. There are certain rules about withdrawing money from your 457: withdraws must begin before the age of 70 but after the age of 59, otherwise a 10% penalty is incurred. If you are retiring before you reach 59 this rule does not apply. Employers do not make any contributions to a 457 on behalf of employees.

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    The importance of using a tax exempt savings plan

    Tax exempt savings plans are one of the most important means you have to save money for the largest expenses in your life: medical expenses, college tuition, and retirement. These plans offer definite advantages that you can't get with a traditional savings account, like pretax contributions and tax free withdraws and interest. The chance to invest money in a tax exempt savings plan should not be passed up because it offers you an opportunity to put away money for some of the largest expenses you'll face.

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    Resources

    Jones, Jen. "Three Main Types of Tax Exempt Savings Plans." SecureLoanConsolidation.com. 2007. 26 April 2009. http://www.secureloanconsolidation.com/articles_three-main-types-of-tax-exemt-savings-plans.asp

    "529 Plan." Wikipedia.org. 16 April 2009. 26 April 2009. http://en.wikipedia.org/wiki/529_plan