Okay, I’m not about to start posting about financial stuff, but this one annoyed me so much I feel compelled to post my findings. I’ve been looking into Roth IRAs for the past few months and I found it incredibly frustrating that no single source clearly communicated the big picture of Roth IRAs. Subtle nuances in language (that the posts don’t explain!) allow sentences to be technically correct, but misleading.
I am not a tax expert of financial advisor blah blah blah, but what follows is the single post I wish already existed somewhere.
There are three kinds of money that can exist in a Roth IRA account
Contribution dollars. This is money that you had in, say, a checking or savings account at your bank, that you have transferred to your Roth IRA account.
Conversion dollars. This is money that you had in a Traditional IRA that you ‘converted’ into a Roth IRA account.
Earnings. This is money that whatever contribution or conversion dollars in your account have earned (I believe earnings are calculated by looking at the cost basis of your account, but I’m not sure about the specifics of how it looks).
100% of the confusion I experienced around how Roth IRAs work stems from the lack of clear definitions - or even mention! - of these three categories of money that can exist in your account. The rules are different for each category!
Simply knowing that three categories exist and that different rules apply to each would have saved me hours of fumbling around the internet. You’re welcome.
Contribution Dollars
You can contribute to your Roth IRA with post-tax money, e.g. money you have in a checking or savings account.
You can only contribute a certain amount. The amount is $6,500 per year for 2023.
If you make a lot of money, there is a limit to how much you can contribute. I didn’t pay attention to this because it’s nooooooot going to be an issue for me.
You can’t contribute more than you earn. So if you only earn $4,000 in a year, you can only contribute about $4,000 to your Roth IRA account. (There are some details about this, e.g. if you pay self employment taxes this will adjust the number, but the gist is that you can’t contribute more than you earn).
Contributions to a Roth IRA are not tax deductible. Unlike contributions to, say, an HSA.
You can withdraw contribution dollars from your Roth IRA at any time. There is no penalty or tax for withdrawing contribution dollars from your Roth IRA, no matter how old you are or how long those dollars have been in your Roth IRA.
Conversion Dollars
Conversion dollars are dollars that you have converted over to your Roth IRA from another retirement account, such as a Traditional IRA.
You can convert as much as you like per year.
But conversion amounts are counted as taxable income, so watch out for bumping up into a higher tax bracket.
You cannot withdraw conversion dollars from your Roth IRA tax and penalty free until those dollars have been in the account for five years.
Earnings
Earnings are the dollars that your contributions and/or conversion dollars earn while sitting in your Roth IRA.
You cannot withdraw earnings from you Roth IRA until you are 59.5 years old unless you meet some specific exception, such as buying a house for the first time or something to do with disability expenditures.
I kept coming across what I thought was contradictory statements of fact about Roth IRA rules. For example, the ability to access conversion dollars tax and penalty free after five years even if you aren’t 59.5 years old yet is well known in the FIRE community.
But I’d come across statements like “You can’t withdraw conversion and earnings dollars until they’ve been in there 5 years AND you’re 59.5”. That sentence is only logically true because earnings can’t be withdrawn until you’re 59.5, so if you’re trying to withdraw conversion dollars AND earnings, you can’t do it until you’re 59.5. But you CAN withdraw just the conversion dollars before you’re 59.5 as long as they’ve been in there for five years.
It sounds confusing, but that’s only because there seems to be some conspiracy to make this stuff more complicated and confusing sounding than it needs to be. (If I disappear from the internet, it’s because the Roth IRA Mafia took me down. Remember me!!)
Resources
This post is intentionally vague on specific numbers because a) they change every year and b) I don’t care about half of them because they don’t apply to me. Do your own research! The point of this post is only to clarify the three kinds of money that exist in a Roth IRA account, and the basic rules that govern each. That said, here are some links to further information about Roth IRAs so you can verify specifics for yourself.
The best two articles on Roth IRA conversion ladder are, of course, the MadFIentist’s two excellent posts from a few years ago:
Those explain the basics of traditional and Roth IRA strategy for people who are taking asset management into their own hands.
The following articles helped me figure out the nuances of the three categories of money:
Okay thanks I just needed to get that off my chest. Now it’s back to regular content like dirtbag engineering projects, postconsumer philosophy, and emotional naval-gazing.