Personal finance radio host and bestselling author Dave Ramsey outlines a key investment strategy for Americans saving for retirement — and a big part of it involves three things to consider when workers choose among traditional 401(k)s, Roth 401(k)s and IRAs.
“Let’s talk about the three things that set the Roth and traditional accounts apart from each other,” Ramsey wrote for his company, Ramsey Solutions. “That includes how your contributions are treated, what happens when you withdraw money in retirement, and your ability to access your funds before and after you retire.”
The primary distinction between a traditional and a Roth 401(k) lies in the timing of your tax bill, as a Roth 401(k) is funded with income that has already been taxed today so you can enjoy completely tax-free withdrawals in retirement.
“But the traditional 401(k) is a pretax retirement savings account,” Ramsey wrote. “When you invest this way, your contributions go in before they’re taxed, which can reduce your taxable income on Tax Day every year.”
“But all you’re really doing is kicking the can down the road, because you’ll have to pay taxes when you take that money out of your account in retirement,” Ramsey continued.
“You can’t escape the tax man forever.”
In addition to 401(k)s, IRAs are also a major part of retirement planning. More on that below.
Dave Ramsey, IRS explain 401(k) withdrawals, access to money
With a traditional 401(k), your retirement withdrawals are taxed as regular income based on your future bracket. Roth 401(k) withdrawals are entirely tax-free because you settled the tax bill upfront when depositing the funds.
“This may sound like something only Captain Obvious would say, but your retirement savings will last longer if you don’t have to pay taxes on your withdrawals,” Ramsey wrote. “That’s why Roth plans have a huge advantage over traditional retirement savings accounts — and why you should take advantage of all the Roth options you have.”
You can’t escape the tax man forever.”
The Internal Revenue Service (IRS) offers a word of warning about making early withdrawals from a 401(k).
“A 401(k) plan is a tax-favored savings plan, designed to help you save money while working toward your retirement,” the IRS explains. “However, the current economy has forced some workers to borrow from their 401(k) plan accounts to pay for critical living expenses, jeopardizing their retirement savings. Before you borrow from your 401(k) plan to get through these tough times, you should know a few things.”
“If you don’t timely repay the full amount of the 401(k) plan loan — including interest — the law treats the unpaid amount as a distribution,” the IRS adds. “This means you generally have to include any previously untaxed amount distributed from your 401(k) plan in your gross income for the year in which the distribution occurs.”
“This amount may also be subject to an additional 10% tax on early distributions unless you are over 59½ years of age, or qualify for another exception to this additional 10% tax.”
Ramsey clarifies access to 401(k) money
With a traditional 401(k), your retirement withdrawals are taxed as regular income based on your future bracket, whereas Roth 401(k) withdrawals are entirely tax-free because you settled the tax bill upfront when depositing the funds.
“Now, if you’re still decades away from retirement, that five years is nothing to worry about,” Ramsey wrote. “But if you’re approaching 59 1/2 and thinking about opening a Roth 401(k), be aware that if you make withdrawals within those first five years, you’ll pay a penalty.”
“But in terms of access, the required minimum distribution (RMD) is the biggest difference between the two types of plans,” he emphasized. “If you have a traditional 401(k), the IRS requires you to start making withdrawals from your account beginning at age 73.”
More on personal finance:
- Charles Schwab, Fidelity alert workers to forced 401(k) rule
- Dave Ramsey warns Americans on 401(k)s, IRAs (he’s not wrong)
- Congress research arm warns Americans on 401(k), IRA penalty
Required minimum distributions are mandatory annual withdrawals from accounts like traditional, SEP, or SIMPLE IRAs and employer retirement plans, which typically begin once you turn 73, according to the IRS.
“Participants in a workplace retirement plan (for example, 401(k) or profit-sharing plan) can delay taking their RMDs until the year they retire, unless they’re a 5% owner of the business sponsoring the plan,” wrote the IRS.
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Fidelity warns about RMDs
Staying ahead of required minimum distributions as soon as you hit age 73 is crucial to avoid severe tax penalties.
“While you were working and putting money into a retirement account, that money was growing tax-deferred,” said Monte Warren, a consultant for retirement offering at Fidelity Investments. “The IRS doesn’t let you hold onto that benefit forever.”
“Eventually, you must start taking money out of the account, paying taxes on any pre-tax contributions and earnings.”
Transitioning from saving your hard-earned money to actually spending it can feel intimidating, but feeling uncertain about withdrawal ages, required amounts, tax impacts, or post-withdrawal options is completely normal.
“People are often confused about some of the essentials governing RMDs,” Fidelity wrote. “In case you are an IRA holder, it is important to be proactive about the process.”
“IRA plan custodians may send you notices about RMD deadlines, or allow you to set up automatic withdrawals for RMDs, but generally you’re in charge of setting everything up.”
Related: AARP warns Americans on 401(k), IRA costly mistakes
