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There are two tax benefits to making tax-deferred contributions to the TSP:
What are the immediate
benefits of making tax-deferred contributions to the TSP?
Tax-deferred contributions are before-tax contributions. When you participate in the TSP, you make before-tax contributions. That means the money you contribute is taken out of your pay before Federal and, in almost all cases, state income taxes are withheld. Therefore, the amount used to calculate your taxes is smaller and you pay less in taxes now.
Your TSP contributions are excluded from the taxable income reported on IRS Form W-2, Wage and Tax Statement, that you receive from your agency each year. Thus, you do not report them on your annual Federal tax return. This special tax treatment does not affect your salary of record for other Federal benefits — such as the FERS Basic Annuity, the CSRS annuity, or life insurance — nor does it affect Social Security or Medicare taxes or benefits.
By paying less current income tax, you have more take-home pay than if you had saved an equal amount that was not excluded from taxable income. Deposits to a regular savings account do not provide such an advantage. To give you an idea of the advantage of saving through before-tax contributions to the TSP, let us suppose, for simplicity, that you are a CSRS participant earning basic pay of $30,000 a year. Let us also assume you are in the 15 percent tax bracket.
If you contribute 5 percent each pay period (or $1,500 per year) to your TSP account, you will owe $225 less (15% (your tax bracket) x $1,500) Federal tax in the current year than if you had not contributed to the TSP. This is because when you save through the TSP, your contributions are not included in the amount on which your tax is calculated. The difference in your tax bill will be even greater if the state in which you live permits tax-deferred savings, as most states do.
What are the long-term benefits of tax-deferred contributions?
By participating in the TSP, you defer (that is, postpone) paying Federal taxes on the money you contribute until you withdraw the funds from your TSP account. In addition, over the years, the money in your account will accrue earnings. These earnings are also tax-deferred. This means that you do not pay income taxes on contributions and earnings in your TSP account until you receive the money — usually after you retire (when your tax bracket may be lower).
Deferring the payment of taxes means that more money stays in your account, working for you. The longer your money is invested, the greater the benefit of tax-deferred earnings will be.
Whether you can also defer state or local income taxes depends on the jurisdiction in which you live, although most states permit such a deferral.