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Investopedia shows a table comparing Roth IRA and traditional IRA.

About tax treatment on distribution from Roth IRA

Earnings grow tax deferred.

Qualified distributions are tax free, including distribution of earnings.

Distributions may be taken at any time.

Distributions are tax and penalty free if qualified.

Does "Earnings grow tax deferred" mean that a distribution from ROTH IRA is subject to tax?

I asked because a similar sentence also appears in the table for traditional IRA

Earnings grow on a tax-deferred basis.

Earnings are added to taxable income for the year distributed.

Distributions may be taken at any time.

Distributions will be treated as ordinary income and may be subjected to an early-distribution penalty if withdrawn while the owner is under the age of 59½

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For the Roth the earnings: interest, dividends, capital gains distributions and capital gains are tax deferred. Which means that as long as the money stays inside of a Roth or is transferred/rolled over to another Roth there are no taxes due.

In December many mutual funds distribute their gains. Let's say people invested in S&P500index fund receive a dividend of 1% of their account value. The investor in a non-retirement fund will be paying tax on that dividend in the Spring with their tax form. The Roth and IRA investors will not be paying tax on those dividends. The Roth investor never will, and the regular IRA investor will only pay taxes on it when they pull the money out.

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tl;dr Roth earnings are not necessarily "tax deferred", but they might be.

This is a great question because IMHO, the use of the wording "tax deferred" is slightly misleading when talking about a Roth IRA (and Roth 401k too).

The phrase "tax deferred" actually means you save tax now and you pay tax later, i.e. you "defer" the tax. As you pointed out, this is the normal terminology used for describing a Traditional IRA/401k. Earnings on a Roth IRA are tax free (not deferred), but only if your distributions are qualified. For the most part distributions are considered qualified if you wait until you are 59.5 years old before taking the money out, but there are some exceptions.

If you choose to distribute more than your contributions, meaning you are now taking out earnings, the earnings are tax free only if your distribution is qualified. For example, if you take out the earnings before you are 59.5 (and no other exceptions apply), then you would pay tax on the earnings and also a 10% penalty. So, perhaps a better way to say it is that earnings in a Roth IRA are "conditionally tax deferred".

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Investopedia probably should change the wording to "tax free" since all of the gains in a Roth IRA can be withdrawn without any additional taxes at retirement time. Tax deferred should only refer to the gains in a traditional IRA. "Tax advantaged" might be a reasonable term to use in both cases.

  • Sorry, but I disagree; Investopedia is correct. As OP quoted, they do distinguish that earnings are tax free if the distribution is qualified, otherwise earnings are tax deferred. Since taxes can't suddenly appear out of thin air, it's better to use the words "tax deferred" unless they are qualified, as opposed to saying they are "tax free" unless they are unqualified. – TTT Jan 13 '17 at 19:06
  • @TTT Or, as I suggest, using the words tax advantaged if you don't want to have to list every exception to the rule. In any case, they didn't list the exception, which caused confusion. That's the nice thing about the internet, everyone can have an opinion. – Nathan L Jan 13 '17 at 19:09
  • OK, I'll at least try to find some common ground with you: I agree it is confusing, and I also agree that "tax advantaged" is a better way to describe it. – TTT Jan 13 '17 at 19:12

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