Tax Free vs Tax Deferred

Investing Tax Free vs Investing Tax Deferred

In case you've heard about Tax free or Tax Deferred investments, I’ll cover this area quickly here as well, although they are just variations on the Bonds and Funds we spoke of in the earlier chapters. There are in fact a couple of different types of tax free investments available to US Investors. However, unless you are a professional, they aren’t likely to be what you think they are. Most Americans refer to their 401k or 529 college savings fund as a “tax free” fund, when they clearly are only Tax deferred. The differences are as follows:

• Tax free: These investments are harder to get your hands on, but when you do, they grow tax free, and the US Government never gets their hands on a penny of your dividends as tax.

• Tax deferred: These are much easier to get, almost as good, but Uncle Sam does get a final slice of the pie at the end… But only after it has grown with the compounding tax advantage.
  Truly

tax-free funds really can be hard to come by. They cost a lot of money to buy into, and they don’t even perform as well as you might think… Because they are strictly some form of government (Municipal) Bond fund. Naturally, their performance is intricately linked to the prosperity of the city in question.

Tax deferral is available to all US Investors in an assortment of many government assisted funds. The US Government has recognized that Social security is declining and the cost of schools in rapidly increasing. To help you offset those costs, one of your absolute best tools to use is “tax deferral,” which basically means not having to pay any taxes, even out of your paycheck, on money you put towards these retirement or School funds. Then while inside, the growth is not taxed in any way, so growth upon growth is never taxed, and so on… The account will clearly grow much faster this way than any taxed fund, but in the end, the US Government does want its' slice of the final pie. This is not exactly tax free, but it’s a little better than halfway better.

The two terms have become quite interchangeable in the modern American vernacular, but only because we have such a lazy mindset for language as a country… As you can see, they mean quite different things!

Anyway, the advantages of tax deferral are clearly nothing to sneeze at! These funds work hard for you in both retirement funds and college funds for your kids. Notice how on the chart below that the green fund does grow like a totally tax-free account, so the tax penalty that you do get at the end is quite acceptable by comparison. We will go much deeper into these investments in the chapters, throughout our investing strategies.

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