Tax-Deferred versus Tax-Free
Course: Fundamentals of Financial Planning
Lesson 6: Educational Savings Techniques
Student Question:
Hello Dan,
I’m working through some of the educational savings vehicles and I see the term tax-deferred and tax-free. But what does each mean? Investment grows tax-deferred. I understand deferred is to pay later, right? My understanding is that it means one does not pay taxes for investment growth. So why is it called tax-deferred and not tax-free?
Meera
Instructor Response:
Hey Meera
A very important distinction now and for future topics. There is a definite difference between tax-deferred and tax-free, even though they sound like the same term. Tax-deferred means taxes aren’t due while funds are accumulating and earning interest. Tax-free means no tax is ever paid.
So, regarding the Coverdell ESA, it is tax-deferred in that the earnings will not be taxed as they accumulate. If I contribute $500 every year to a Coverdell for 10 years, and it grows to a value of $15,000, then I would have $5,000 in contributions and $10,000 of earnings. At the end of 10 years, I would not have paid any taxes on those $10,000 of earnings. That is what tax-deferred growth is.
Now, regarding tax-free, with the Coverdell, if I use those funds to let’s say put a pool in my backyard, I am going to pay taxes on that $10,000 of earnings. However, if I use that money for qualified education expenses, then I won’t pay any tax. That would make it tax-free growth.
In summary, tax-deferred means I don’t pay taxes while earnings are accumulating, and tax-free means I never pay tax on the earnings. You’ll see this come up again in income tax and especially retirement planning.
Dan
