Originally Posted by TSP.gov
Tax-Deferred Contributions
There are two tax benefits to making tax-deferred contributions to the TSP:
Your TSP contributions are taken out of your pay before taxes are withheld, so you pay less tax now.
Taxes on contributions and attributable earnings are deferred until you withdraw your money.
What are the immediate benefits of making tax-deferred contributions to the TSP?
Tax-deferred contributions are ''before-tax" contributions. In other words, 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, so you pay less in taxes now. Deposits to a regular savings account do not provide such an advantage.
Your TSP contributions are excluded from the taxable income reported on the IRS Form W-2, Wage and Tax Statement, that you receive from your service 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 uniformed services retired pay — 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. To give you an idea of the advantage of saving through before-tax contributions to the TSP, let us suppose, for simplicity, that you earn $30,000 a year and that you are in the 15 percent tax bracket. If you contribute 5 percent each month (or $1,500 per year) to your TSP account, you will save $225 in Federal taxes (15% (your tax bracket) x $1,500 = $225). If you had simply deposited the $1,500 in a regular savings account, you would have owed $225 in Federal taxes. Your tax savings will be even greater if the state in which you live (or of which you are considered a legal resident) allows you to exclude TSP contributions from taxable income, 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 your TSP account contributions and earnings 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.
