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Dave Says
Advice from Nashville's leading Financial Aid Advisor Dave Ramsey
Author of Financial Peace and The Total Money Makeover

What are the Differences in Roth IRA and 401(k)?

Dear Dave,
I was listening to one of your videos that included a talk about investing and you made the comment that you ought to max out your Roth IRA if your 401(k) doesn't offer matching funds from your employer. I'm a little confused because you put different amounts of money in each of those.
With a 401(k) you invest pre-tax, so you put $1,000 in there - compared to taking it home where it would only be $700 after taxes - but you pay the taxes later when you withdraw they money. If you invest in a Roth IRA, you invest with money that's already been taxed, so you're putting less in the Roth, but it gets to grow tax free.
Greg in Huntsville, Ala.

Dear Greg,
This is assuming you actually did put less in the Roth and I'm not suggesting you do that.
Let's compare apples to apples for a second. If we have $1,000 to invest and we brought it home, it would turn into $700 due to taxes. So if we put $700 into the Roth and we put $1,000 into the 401(k), assuming they're in the exact same investments and they grow the exact same amounts, later the $300 difference we put into the pre-tax investment will grow to exactly enough to pay your taxes in that investment. So it's a wash, because the 401(k) is taxable when you withdraw it and the Roth is not. So you don't win.

Now, let's say you do what I always suggest, which is save like a maniac and retire a multi-kajillionaire. Now your 401(k) and IRA mandatory withdrawals at 70 percent are going to drive you into the top tax bracket at retirement. For sure my plan is right then.
If you want to twist that even further and say, "Well, let's just put $1,000 in the Roth." We're not really comparing apples to apples mathematically, but I'm not doing theory here, I'm living life - now we've totally beat the 401(k).

So if you're going to do exactly the same pre-tax or after-tax investing in the same exact investments and the tax brackets are exactly the same, the outcome is exactly the same when all the smoke clears. But if you're going to put a little more into the Roth or if you're going to have a lot in there at retirement, which will drive you into the top tax bracket, then the Roth IRA is going to be better. I'm a huge fan of the Roth IRA, but we'll certainly always do 401(k) and 403(b) up to the matching amount. Then we'll do the Roth. And what I'd really like you to do is get out of debt so you're just fully funding everything.
- Dave

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