Personal finance guru Dave Ramsey recently weighed in on the topic of 401(k) retirement plans and a lesser-known enhancement to the concept called the “Roth 401(k).” And I have to say:
I’ve rarely seen a concept explained more clearly in 45 seconds than Ramsey did in this video.
Here is the text of what Ramsey said, in full:
“The Roth mathematically kicks the traditional [IRA’s] bottom. And here’s why: If you take $200 a month from age 25 to age 65, 40 years, and invest it in a decent growth stock mutual fund, you’ll have $2.5 million in there.
However, only $96,000 of the $2.5 million is the actual principal you put down. So if you have made a [401(k)]you would have got a tax break for $96,000. You still wouldn’t have paid taxes on the $96,000. But you’ll pay taxes on the entire $2.5 million as you take it out.
If you did that with a Roth instead [401(k)]you would pay taxes on the $96,000 [before you put them in the plan as your contribution] and zero taxes on the rest of the two and a half million.”
As I listen to the explanation, it seems clear to me. But let’s take this step by step and see if we can make it a little more systematic.
This post was updated on January 26, 2025 to include a section on when a regular 401(k) might actually be preferable to a Roth.
Created under the Revenue Act of 1978 as section 401(k) of the Internal Revenue Code, 401(k) plans began to become popular in the early 1980s and really gained momentum as defined benefit pension plans fell out of favor in the 1990s. Then, in 2001, the Economic Growth and Tax Reconciliation Act created a new savings vessel called the Roth 401(k), and it became available to employers on January 1, 2006.
So 401(k) plans have been around for almost 50 years and Roth 401(k)s have been around for almost 20 years, even though many workers don’t know much about the latter. What is the big difference between the two?
It works like this. (I should say it works “very roughly” like that. Consult your tax advisor for details). Let’s say you earn $50,000 and, between your own and employer contributions, you decide to put 10% of your salary, or $5,000, into a 401(k) plan. That $5,000 contribution is made pre-tax, meaning subtracted from your taxable income, so before you change it, your taxable income just dropped to $45,000. By the way, you just dropped out of the 22% tax bracket and the 12% tax bracket!
Pretty cool, right? Plus, over the years between now and retirement, your $5,000 contribution (plus contributions you make in future years) grows tax-free. Only when you retire and start making withdrawals from your 401(k) do you pay taxes. But you pay taxes on every penny you retire
The Roth 401(k) is different. Here, you first pay taxes on your $50,000 of income, and then deposit $5,000 of what’s left over. Once again, the money in your account grows tax-free until retirement. Then, when you start making withdrawals, none of the money you withdraw is taxed. Every penny, contributions and capital gains alike, is tax free.
And now you see why Dave Ramsey prefers a Roth 401(k) over a regular 401(k). But what if you already have a 401(k)? Are you stuck with the “inferior” version of the pension plan?
Not necessarily, no. You can always open a Roth 401(k) in addition to your original 401(k) prescription. You can even put some money into both plans as long as you don’t exceed the annual contribution limit (which is $23,000 for tax year 2024).
You can also move funds from your 401(k) plan into a Roth 401(k) or even convert your entire 401(k) to a Roth 401(k), assuming your employer allows it or you have an individual plan.
Now, we’re dealing with complicated tax laws, so you almost certainly will certainly You’ll want to consult a professional tax advisor about the best way to do this. And one of the first things your advisor will tell you is that you’ll have to pay taxes on the money you move or convert. And if you’re in a pretty high tax bracket right now, that’s going to hurt you.
It’s a short-term pain, though. And according to Dave Ramsey, the long-term gains will be more than worth it.
While Dave Ramsey generally prefers Roth accounts, a traditional 401(k) is not without value. And in some cases, it might be a better strategic choice:
Lower fees now: If you expect to be in a lower tax bracket in retirement than you are now, deferring taxes until later can lower your lifetime tax bill.
Higher salary at home: Because traditional contributions reduce your taxable income now, you keep more of your paycheck today, which can help with your current cash flow or pay down debt.
Investment flexibility does not change: Whether Roth or traditional, the range of investments offered in your plan is usually the same; simply the tax treatment differs.
Employer matching is still valuable: Many financial professionals recommend contributing at least enough to maximize employer match before worrying about tax treatment. As they say, “match beats Roth beats traditional.”
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