Many American workers planning for retirement start by deciding which investments they plan to use — and these often include 401(k)s and Individual Retirement Accounts (IRAs).
Bestselling personal finance author Dave Ramsey is a fan of using both approaches, but wants Americans to be aware of some advantages and disadvantages of each.
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First, it's important to understand a little about what these accounts and plans are and how they differ from each other.
A 401(k) plan is sponsored by an employer, which often involves the employer matching contributions workers make from their paychecks.
The money contributed to 401(k) plans is tax-deferred, so workers don't have to pay taxes on that portion of their income until they retire and start using that savings for living expenses.
A Roth IRA account also involves an individual investing in a retirement account. But the key feature with Roth IRAs is twofold: The money grows tax-free and also allows for tax-free withdrawals after the worker investing in it retires.
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Dave Ramsey explains some disadvantages of 401(k)s
Workers who invest in 401(k) plans take advantage of employer matches and also have higher amounts they can contribute than exist for Roth IRAs.
While Ramsey emphasizes that 401(k)s are a great piece of one's retirement strategy, he also notes a few disadvantages for them as compared to Roth IRAs.
One, the worker contributing money to a 401(k) plan has fewer options for mutual funds from which to choose.
In a Roth IRA, individuals have many more investing options.
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"With a Roth IRA, you’re not limited by some third-party administrator deciding which funds you can invest in," Ramsey wrote. "You literally have thousands of mutual funds to pick and choose from."
And in 401(k)s, as already mentioned above, withdrawals made after a person retires are taxed. The contributions made while building the 401(k) are made pretax, but it's when using it to fund retirement living that taxes are paid.
The 401(k) also has a penalty for withdrawing funds too late. So people must begin withdrawing some of their savings by age 73 if they have become 72 in 2023 or later.
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People are limited to investing only up to $7,000 in a Roth IRA in 2024. That number is $8,000 for people aged 50 and older.
"When you compare that with the 401(k) contribution limit ($23,000 for 2024), you might be thinking, 'That’s it?'" Ramsey wrote. "Yep. That’s why 401(k)s and Roth IRAs work better together."
There's another disadvantage to Roth IRAs. People can not take money out of their accounts until five years after their first contributions.
People who pull money out of their accounts early anyway will face penalties and taxes. There is also a penalty for taking money out of a Roth IRA before age 59-and-half. But these are generally things that can be avoided with some smart planning.
Ramsey is a big advocate of making these two retirement investing strategies work together. He suggests investing in both accounts.
He explains that, that way, workers can get the advantages of matching funds from their employer in the 401(k) plan as well as the Roth IRA's tax benefits.
And many companies are now offering Roth 401(k) plans, which combine the benefits of each in one plan.
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