Person using calculator

Understanding the Power of a Roth IRA

05/15/24

An increasing number of retirees who did well to save enough for their retirement are discovering the downside of leaning too heavily on pre-tax investing in their 401(k) plans and IRAs. With the immediate tax deduction and the advantage of tax-deferred earnings inside the account, it seemed like a good idea at the time. However, once they start drawing down from their plans, the income becomes taxable, often pushing them into a higher tax bracket.

Worse, it can also trigger the “tax torpedo” on as much as 85% of their social security income. Suddenly, their projected cash flow is not what it was supposed to be. Even worse, if they avoid drawing down from their 401(k) or IRA to reduce their taxable income, they run straight into the Required Minimum Distribution (RMD) rule at age 72, which can push them into an even higher tax bracket.

For these reasons and more, financial planners are now looking to the Roth IRA as a critical income planning tool for avoiding tax traps and extending cash flow in retirement.

How Does a Roth IRA Work?

A Roth IRA differs from a traditional IRA in two ways. First, contributions to a Roth IRA are made with after-tax dollars instead of pre-tax dollars with a traditional IRA. Secondly, withdrawals from a Roth IRA in retirement are tax-free, whereas IRA withdrawals are taxed as ordinary income. As with a traditional IRA, earnings inside a Roth IRA grow tax-free.

Contribution Limits

For 2023, you can contribute up to $6,500 to a Roth IRA ($7,500 if you’re 50 or older) if your earned income (modified adjusted gross income – MAGA) is less than $153,000 ($228,000 for joint filers). Your contribution limits are phased out if your MAGA is between $138,000 and $153,000 ($218,000 and $228,000 for joint filers).

The Advantages of a Roth IRA

In addition to generating tax-free income, the two big tax advantages of a Roth IRA over a traditional IRA are that the income is not subject to the RMD rule and is excluded from the social security tax calculation, thereby avoiding the tax torpedo and extending your cash flow even further.

If that were the extent of what a Roth IRA offered, it would still be considered a tremendous retirement savings and income planning tool. But itrsquo;s also a multi-faceted planning tool that offers other important financial solutions, including:

Down Payment for Buying a First Home

When used to buy a first home, homebuyers can withdraw up to $10,000 from a Roth IRA tax and penalty-free if it has been open for five years. It can be used for a down payment even if it hasnrsquo;t been open for five years, but yoursquo;ll need to pay taxes (no penalty) on any earnings withdrawn. Spouses can join together to withdraw up to $20,000.

Paying for College Expenses

While a Roth IRA should be used to target your retirement goals, it can also be used as a source for college funding. Parents can tap into the contributions portion of their account so there wouldnrsquo;t be any taxes owed on the withdrawal, which would also be penalty-free if used for eligible college expenses.

Use it for Whatever

While itrsquo;s not recommended, if you have held a Roth IRA account for at least five years, you can access your contributions tax-free, anytime, and for any purpose. However, if you access it before age 59½, you will pay a 10% penalty.

Diversify Your Retirement Income

The real power of a Roth IRA is its ability to diversify your retirement income. If your income sources are primarily tax-deferred or taxable accounts, it could push you into a higher tax bracket. You could also fall victim to the social security tax torpedo. Due to its tax-free status, income from a Roth IRA can help you avoid unnecessary taxation and extend your cash flow further into retirement.

Personal – Saving, Planning & Budgeting

Ready to explore how Sunflower Bank can assist you? Speak to a personal banker at a branch near you, contact a specialist on our Wealth Management team, or find the right financial partner on our Commercial Banking team for your business needs. 

Back to Resource Articles

This article contains general information only. Sunflower Bank is not, by means of this article, rendering accounting, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, before making any decisions related to these matters, you should consult a qualified professional advisor.