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