Almost 95% of American workers who are thinking about retirement begin by figuring what types of investments to use for savings and often include 401(k)s and Individual Retirement Accounts (IRAs) in their plans.
Best-selling personal finance author Dave Ramsey is a proponent of utilizing both methods, but advises Americans to be mindful of their benefits and drawbacks.
It’s essential to understand the basics of these accounts and plans and how they’re distinct from one another.
An employer typically offers a 401(k) plan, which sometimes includes the company matching a portion of the savings workers contribute from their income through automatic payroll deductions.
Contributions to 401(k) plans are tax-deferred, which means workers don’t pay taxes on that part of their earnings until they retire and use those savings to cover everyday living expenses.
A Roth IRA account also involves an individual investing in a retirement account. The key feature of Roth IRAs is two-fold: the money grows without being subject to taxes, and also allows for withdrawals to be made free of taxes after the investor retires.
These are just a few downsides to 401(k)s, but if you only know these few benefits of retirement the plan they can seem a very attractive to you.
Workers who invest in 401(k) plans get the benefit of employer matching funds and are allowed to contribute larger sums than they can with a Roth IRA.
Ramsey stresses that 401(k)s are a great part of one’s retirement plan, but he also points out a few downsides to them compared to Roth IRAs.
One thing a worker contributing money to a 401(k) plan has fewer choices in terms of the mutual funds from which to pick.
In an Individual Retirement Account (Roth IRA), individuals have a lot of different investment choices available.
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You have literally thousands of mutual funds to choose from.
As I mentioned earlier, in the case of 401(k)s, withdrawals made by individuals after they retire will be subject to taxes. Contributions made while building up a 401(k) are made before taxes, but it’s when using these funds to support post-retirement living expenses that taxes come into play.
The 401(k) also has a penalty for withdrawing funds too late. Therefore, individuals must start making withdrawals from their savings by the time they are 73 if they turned 72 in 2023 or later.
There’s a lot more to Roth IRAs than meets the eye, according to Dave Ramsey. Specifically, he notes that you can only contribute to a Roth IRA if you have earned income, and that conversion rules can be complex. If you have a traditional IRA, you can convert it to a Roth IRA, but this conversion is a taxable event that can trigger a significant tax bill. “You might think you’re saving taxes, but really you’re just deferring them into a future tax liability,” Ramsey says. In this article, we’ll explore some of the lesser-known rules and nuances of Roth IRAs to make sure you’re getting the most out of your retirement savings.
For 2024, individuals can only contribute up to $7,000 to a Roth Individual Retirement Account (IRA). However, individuals 50 years or older can contribute up to $8,000 to a Roth IRA.
When you compare that to the yearly 401(k) contribution limit ($23,000 for 2024), you might be thinking, ‘That’s it?’” Ramsey wrote. “Yes, that’s why 401(k)s and Roth IRAs work better together.
There is another drawback to Roth IRAs to be aware of. People are unable to withdraw funds from their accounts until five years after their initial contribution.
Individuals who withdraw funds from their accounts prematurely will incur penalties and taxes. There is also a penalty for withdrawing from a Roth IRA before 59-and-a-half. However, these penalties can often be mitigated with some strategic planning.
Ramsey is a strong supporter of combining these two retirement investment strategies. He recommends contributing to both accounts.
He explains that, in doing so, workers can benefit from receiving matching funds from their employer in the 401(k) plan and also take advantage of the tax benefits offered by the Roth IRA.
And many companies are now offering Roth 401(k) plans, which combine the benefits of each in one plan.
