When American workers first enter the workforce, they often do so with varying degrees of understanding about what 401(k) plans are and how to contribute to them.
Personal finance radio host and bestselling author Dave Ramsey is often approached by questioners and advice seekers about either getting started with a new 401(k) plan or looking for ways to improve an existing plan.
Ramsey employs various techniques to both educate people about 401(k)s and to bluntly warn them about the importance of making informed decisions about their retirement savings.
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The education piece of this was captured in a recent TikTok video, in which a caller to The Ramsey Show inquired about his company’s 401(k), which he felt was not performing well.
“The 401(k) itself is not an investment,” Ramsey said. “It is how the investment is treated under section 401, subsection K of the IRS code. Meaning that you’re allowed to have money taken out of your check and put into an investment. Then it grows tax-free if it’s a Roth 401(k), or tax-deferred if it’s a regular 401(k).”
“What’s been underperforming is not the actual 401(k),” Ramsey told the caller. “It’s more like the coat that is keeping the investment warm. It’s the investment inside the coat that sucked. If you had an underperforming 401(k), what you really have is an underperforming investment in your 401(k).”
Dave Ramsey warns workers on 401(k)s
Ramsey has blunt words for Americans wondering about whether the mutual funds in their 401(k) plans are solid investments — and how much they should be contributing.
“If you’re leaning on your 401(k) to be a big part of your plan for retirement, it’s important to get your questions answered,” he wrote. “Your golden years literally depend on investment choices you make today.”
A 401(k) is a retirement savings program provided by employers, Ramsey explains. These plans, along with other similar workplace-sponsored options, enable employees to contribute a portion of their wages directly into a retirement account.
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If a person’s employer offers a 401(k), they will typically complete an enrollment packet that outlines details such as vesting schedules, beneficiary designations, and available investment choices.
There are two primary kinds of 401(k) plans: Traditional and Roth. While both are designed to help employees save for retirement through their employer, they differ in how contributions and withdrawals are taxed.
If both are offered, Ramsey recommends using the Roth 401(k). The money grows tax-free for years, and withdrawals are made in retirement without worrying about taxes, as they have already been paid.
Traditional 401(k) plans
- Contributions to a traditional 401(k) are made with pre-tax income.
- This means the money is deducted from your paycheck before federal income taxes are applied.
- As a result, your taxable income for the year is reduced, which can lower your overall tax bill.
- The tax benefit is received in the year the contributions are made.
- Investment earnings within the account grow tax-deferred over time.
- Taxes are not paid on contributions or earnings until funds are withdrawn, typically during retirement.
- Withdrawals from a traditional 401(k), including both your contributions and any investment gains, are taxed as ordinary income.
- This structure defers your tax liability to retirement, when you may be in a lower tax bracket.
Roth 401(k) plans
- A Roth 401(k) allows for tax-free investment growth and tax-free withdrawals during retirement.
- Contributions to a Roth 401(k) are made using after-tax income, meaning taxes are paid before the money enters the account.
- Unlike a traditional 401(k), there is no immediate tax deduction for Roth contributions.
- The benefit comes later, as qualified withdrawals—including earnings—are not subject to income tax.
- This approach favors long-term tax advantages over short-term tax savings.
- Employer contributions to a Roth 401(k) are treated differently; they are made on a pre-tax basis.
- Taxes will be owed on employer contributions and any associated investment gains when withdrawn in retirement.
Dave Ramsey warns Americans about early 401(k) withdrawals
Withdrawing funds from a 401(k) before reaching retirement age can be financially burdensome and is generally discouraged except in urgent situations. Early withdrawals are best reserved for critical circumstances, such as preventing bankruptcy or foreclosure.
If one is under the age of 59-and-a-half, the amount they take out will typically be subject to ordinary income tax and an additional 10% early withdrawal penalty.
“Taking an early 401(k) withdrawal is one of the worst moves you can make for your long-term financial future,” Ramsey wrote. “We’re talking a one-two punch of taxes and penalties that’ll knock you out.”
“And on top of that, you’ll miss out on all the investment growth that money could have made if those funds had stayed in your 401(k),” he continued. “You’d be robbing your future self of a lot more money than what you withdraw today.”
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