Dave Ramsey Might Think I’m Crazy. Here’s Why:

UntitledWhen I first read, Total Money Makeover, back in 2003, I was excited to find another personal finance expert that shared my recommendations regarding saving for retirement.

One of Dave’s core tips regarding investing is,

Get your free money first with your 401(k) match. After that, take advantage of the Roth IRA to get your tax-free money. Then go back to the 401(k) and max it out.

This is the same advice that I’ve been giving to individuals ever since I became a financial advisor.

But over the last year or so my opinion has changed. What I’ve realized is that the majority of people that save in their 401(k) s have no idea what they’re doing.

They’ve usually let their employer decide where to put their money and they never really have no clue in what they are investing into. 

Are you one of these people?

{Ahem.}

Because of this, I have changed what I believe.

The Change

I believe that everyone should first, if eligible, open a Roth IRA.

Yes, that’s right Dave.

I’m a big believer and lover of tax-free money and, if available, to me I’d max out my Roth IRA in a heartbeat.

Unfortunately, I’m one of the unlucky ones that doesn’t qualify. :(

Note: Not sure if you qualify?  Check out the most recent Roth IRA Rules.

So you’re probably wondering why would I advocate first going to the Roth IRA instead of the 401(k)?

I don’t blame you for questioning. Here’s my logic….

What I See

I believe that people need to have more of a hands-on approach with their investments. By having to open a Roth IRA it requires you to go out and do research in where the best place is to open a Roth IRA.

You’ll then have to figure out a way to get the money into it, and forced to learn how to choose the investments you place inside it. At worst, you’ll have to sit down with a financial planner to help you make sense of it all.

Essentially, it makes you do some work; it makes you have some stake in the game – your game!

Without any stakes in the game you’ll just go through the motions and never really know where or how your money’s being invested.

What About Taxes?

Is there some flaws in my logic? Of course there is! Any tax expert could punch holes in this concept all day long.

But here’s what I know: I’ve talked to several, potentially hundreds of people over the years that don’t have the slightest clue what they are doing with their retirement money which is most often their 401k.

This needs to stop.

You think Dave Ramsey will call me nuts?

Let me know in the comments below.

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Comments | 24 Responses

  1. says

    When my employer suspended matches to our 401(k) I actually considered switching my contributions over to my Roth IRA. I never did but it still crosses my mind.

  2. says

    Well Jeff, I definitely understand your reasoning for the change but I am going to have to go a little more into the details.

    My thought would be this – if someone has the insight to research Roth IRA’s and their benefits as well as what they should invest in once funded, they should now also now know how to select a fund from their 401(k). So, why not go back and get the guaranteed money first?

    Even if they just selected a target retirement fund at the Roth IRA company, most 401(k)’s offer that type of option now. Why wouldn’t they just invest in that?

    Being a tax guy too, I just feel that having all of that pre-tax money in the 401(k) PLUS the match will really do wonders in the later years of compounding interest.

    Just putting my two cents in!

    • Jeff Rose says

      @ Adam. Thanks for the input!

      Yes, that does make sense, but I think the real issue is getting people off their butt to really do the research. Frankly, I’m so tired of people really having no idea is going on with their 401k investments. And it’s not just young people.

      I’ve talked to several people who have a couple hundred thousand dollars (between $100k-$500k) in their 401k and don’t have the slightest what it’s invested into. How crazy is that?

      • says

        Regarding your comment, “You’ll then have to figure out a way to get the money into it, and forced to learn how to choose the investments you place inside it.”

        Regardless of if the account is a 401(k), traditional IRA, Roth IRA, I don’t think investors feel “forced to learn how to choose the investments.” In my experience, most investors need the help of someone with financial expertise to feel confident with their allocations and investments despite the type of account. Thus, I don’t think this is a main driver of opening a Roth IRA vs. contributing to a 401(k) (or traditional IRA). Obviously, the tax differences of a Roth IRA and 401(k) (or traditional IRA) need to be considered.

        Though I do believe investors should take advantage of a company match and max out this 401(k) option, there is one thing to consider after making this contribution. One advantage an IRA account (traditional or Roth) offers an investor additional contributions to a company 401(k) – the number of investment options. With help or not with help, investors traditionally have many more investment options in an IRA account through a brokerage firm. Once again, I prefer investors max out their 401(k) plans match first.

        • says

          Regarding my note above, this should read, “One advantage an IRA account (traditional or Roth) offers versus an investor making additional contributions to a company 401(k) after reaching the company max – the number of investment options.”

  3. Chad says

    ALWAYS get that free money first from your employer, no matter if you understand what that money is being invested in or not. You cannot guarantee a better return on your money than 100%, which is what an employer match is. Once you are contributing up to your match, then max out your Roth IRA. Find an advisor you trust, show him/her the list of options in your 401(k) and have him/her help you with your allocation.

    • says

      What I think Jeff was getting at is that if you were to just utilize the default fund at your 401(k) (usually the money market fund), you would be much better off just investing it in a Roth IRA and learning about the investments.

      Even with a 100% immediate return from the match, eventually you will lose the battle of inflation and the more aggressive investment in the Roth IRA will outpace it. It may take 7 -10 years but you will eventually double your money in the other investment.

      However, I am still on the side of taking the match first and learning about the investments inside of it. Just check out my comment above.

      • Chris says

        I understand his point, but no one is going to be able to “understand” what they are investing in enough to improve 50 or 100% over the match amount. While it seems like Jeff just wants people to wise up better about the choices they are making in their 401k (a noble cause), I think it is more important to have them wise up about what’s better up front. Invest $100 and get $100 in investments, or invest $100 and get $150 or $200 in investments. That’s a no-brainer even if the $150 or $200 in investments are inferior choices. The headstart involved will not be overcome.

        • Jeff Rose says

          @ Chris

          Trust me, I’ve thought the same for a long time “get the free money first”. Let me give you a personal story that illustrates my point.

          Person was fully maxing out their 401k and obviously getting the match. Had been doing so for a number of years and had almost $300k saved up. When I asked about their investment strategy with the investments they were clueless.

          When I dug deeper with their fund selection, many of them were pure crap. Even worse, they actually have some decent funds they could have been utilizing. Doing some back testing (I know it’s not a guarantee but at least it gives us an idea), they had left between 3-4% net annualized return on the table.

          Why? Because they didn’t do any research.

          In this case, I could easily argue, that even with the free match, they would have been much better off doing some research and opening a Roth IRA. You can obviously make the case for doing the 401k now that they’ve researched it as Adam pointed out.

          But the other issue, which I didn’t touch upon in the post is that most 401k’s suck. At least regarding their investment choices. I’ve encountered a few really good ones, a lot of mediocre ones, and even more that are just plain awful.

          Thanks for your comments!

          • Chris says

            I don’t think anyone here is disagreeing that 401ks might not have the best options. However, 401k matches cannot be beat. To beat the match each and every year you would have to be earning either 50% or 100% returns on your money to stay ahead of the game. (On top of that, I’m assuming you are getting absolutely ZERO return in a 401k, which is hard to imagine in an environment where outside of a 401k you are earning 50 or 100% annual returns). Like I said, your goal here is noble, however your path to that goal is unsound and indefensible financial advice.

        • Mike says

          Jeff, while I agree 100% with your underlying point about every individual taking a bit more personal responsibility in learning about basic investing, how to open up accounts, etc. I disagree with surface level change of heart and logic here because: 1) most plans I run into now default into some kind of balanced fund–RARELY do I run into a plan that defaults into the Money Fund., 2) I still think you need to get the match first always, 4) Many companies are offering ROTH 401k options–while the match is still tax differed, you can in some sense kill two birds with one stone, and finally 4) some folks just will not learn no matter how much we preach to them–the simplest you can make it for them the better (I.E. automatic contributions to a 401k, easy sign up, heck even the balanced fund is better than doing nothing which is still unfortunately what many people do). I will stick to your original line of recommendation. Oh, one last thing. If folks are coming to me asking order of savings, etc., they are likely already smart enough to figure out how to open up those things, the allocation discussion often just springs forth as part of this conversation.

          • Mike says

            Another point, while i agree with you many times that the plan funds can be crap, I also see a lot of “self-learning” as being “follow the herd investing”, meaning they may be far more likely to get themselves into real trouble by buying the hottest thing via CNBC or cocktail investing vs. intelligent asset allocation and could very well end up severely NEGATIVE vs. if they had just held the money fund and gotten the match!

  4. Bobby Diehl says

    i am loving this conversation. I believe completely in putting money in your 401K only to what your company match is, and opening and maxing out your Roth IRA. After that, my take is maxing out your pre tax bucket of money is not exactly the best way. Why? I believe that at some point income tax rates will increase, and when that does, uncle sam will dip into that pre tax bucket even more. If you take advantage of the “free” money and then get as much of your money into “tax free” vehicles that you will be better off. Jeff knows me pretty well as we have bounced ideas back and forth….I also believe a very tangible asset to have in your portfolio is Cash Value Life Insurance, but it must be with a Mutual Company for it to do what its supposed to.

    Plus, when a client actually has to stroke the check to apply to the Roth and CVLI, they know why they are doing this. my experience has shown me that people put money in the 401k and dont know why, what its in, and say if they take it before i get it i dont miss it. The client has to be engaged with purpose to make it work.

  5. says

    You are not nuts! Most 401k plans offer a fairly pathetic array of mutual funds with high expense ratios. Most people I know just pick “target date funds” or other funds based on the name, with no knowledge of the underlying expense ratio they pay or other potential costs. With a Roth IRA, you have so many more options for investing your money, and like you say, it forces a person to investigate, learn, and make a conscious choice versus just filled out some paperwork, forwarding it to HR, and then forgetting about the whole thing.

  6. says

    Hi Jeff, you’re not nuts. Besides Dave Ramsey is not the end-all be-all of personal finance (although some may think so). We don’t need to listen to someone’s way of thinking just because it’s what they believe is right. Everyone has different situations and personal preferences, so I think your reasoning is sound and I, too, can see why you would encourage someone to go with the roth first.

    I was in the same boat and signed up for my 401k with my employer. They automatically invested my money in a target retirement fund. I went off to consider investment options for my roth and found out that a target retirement fund was the way to go as well as another health fund. It was a great way to figure it all out, but in the end I ended up sticking with what my employer chose for me for my 401k so it all worked out in the end. I do, however, have a riskier target retirement fund for the roth…so it’s kinda different!

  7. says

    I understand all of the talk about getting the employer match from the beginning, I really do, but what is being ignored is the fact that sometimes you don’t get the full benefit of that match. What I mean is that there are some (if not many) companies that don’t give 100% vesting right off the bat. Some prorate it out over a half a decade or more. The last CPA firm I was with had no vesting until the 3rd year, which was only 20%, then it went up in intervals until the total employer match was 100% vested after 7 years or so. Now what happens if after a couple years, you decide that there are better opportunities? Or if the economy tanks again? If you aren’t fully vested, you have to essentially give back the unvested portion when you cash out. It’s really very short-sighted if you think about it.

    Also, in regards to the question of getting the free money even if the options are poor within the plan….wouldn’t it be better to use the money in a Roth investing in much better options and making up the difference? Let’s say the 401(k) has 10 options that are all losers YTD. In the IRA, you can go with ANYTHING under the sun (as long as the brokerage house give you access). Essentially you are giving up the free money, which would probably lose value anyway and instead opting to invest in something that at the very least pays a nice dividend to offset losses or even better–add to gains.

    In terms of the tax issue, if you can contribute to a Roth, I always say do it! Unless of course you don’t plan on being successful and having a lot of income in retirement. Especially in the case of the college kids Jeff spoke to, they will benefit much more from paying tax on that $5,000 now versus potentially having to pay tax in retirement when their incomes should be significantly higher, not to mention the possibility of higher tax rates, or any other unforeseen events. Not to mention the fact that later in life, the deductions either phase out or aren’t enough to itemize and bring down the taxable income.

    • says

      Good points regarding the vesting period, as that is often overlooked.

      Regarding your comment, “Let’s say the 401(k) has 10 options that are all losers YTD. In the IRA, you can go with ANYTHING under the sun (as long as the brokerage house give you access). Essentially you are giving up the free money, which would probably lose value anyway and instead opting to invest in something that at the very least pays a nice dividend to offset losses or even better–add to gains.”

      I need to make one point.

      Assuming you are vested, I don’t know of anyone on the planet who consistently gets 100% returns investing so investors should take the 401(k) match. I will take the 100% head start via a company match vs. an IRA (or even a 20% head start, if 20% is vested after year 1, and 20% more vests each year through 5 years). Why wouldn’t you do this even if you think all the investments will “probably lose value anyway,” or you may leave the firm? It is unlikely the 401(k) investments will lose 100%, or that you will make 100% in your IRA, and it is also unlikely for most investors to get close. Take the match, and then consider the IRA.

      I have yet to find many professionals that can repeatedly beat the markets by outsized margins. So, just because an investor has more flexibility in terms of investment options in an IRA, that is no guarantee of exceptional trading skills and performance.

    • Jeff Rose says

      @ Eric

      My wife who used to be a 401k coordinator at a major hospital in our area was glad you brought up the vesting schedule. Another point she added is that many employers don’t give $1 for $1 match, say $.50 for the first 3%, etc. So the “free money” isn’t always as grand as it seems.

  8. CSL says

    Hi Jeff,

    In the business as well and need to take the other side like many of the people commenting. The people who don’t take the time to research their 401(k) options, or even reach out to a financial advisor to ask for help, are not the ones who will become stronger investors by “learning” to open and fund their IRA first. They will have that mindset to everything dealing with retirement planning.

    Also, the majority of people taking a laid back approach to their finances are not the ones maxing out both IRA and 401(k). So here, even missing some return by being in mediocre 401(k) funds is overshadowed by that immediate 100% return on invested monies. That needs to be their starting point.

    In an ideal world, you are correct. Your advice is teaching the man to fish, not just giving him a meal. It’s just that in my experience with clients, I’ve never seen an instance where the IRA should have priority over a strong company match.

    Enjoy your site, though. Just started following it recently.

  9. says

    While I believe that people should know what is going on in their 401k I don’t think opening a Roth IRA first is always the answer. I think people saving something for retirement is better than putting off opening a Roth IRA and saving nothing. Now if you know for sure the person is disciplined and will get on it to open the Roth IRA then I could agree with the idea, but unfortunately most people that don’t know what is going on with their 401k probably won’t care too much to go through the effort to open a Roth IRA.

  10. says

    I agree with the premise to get people to get educated with their investments. Maybe you’ll at least get people asking about their match and if they’re even fully vested. That being said, being a tax guy myself, I will always go for the free money first. Get educated, find the best options you can within your 401k and invest up to the match. I’ll always stick to that and the math agrees with me :)

  11. Jennifer says

    Hi Jeff-
    Ok. My company did not have a 401k when I started working, but began one last year. They do not do matching so I did not sign up. I have a RothIRA which I max out at the 5k/year. So I’m essentially following your advice, but what would you say would be the next step under this logic?

    • Jeff Rose says

      @ Jennifer I’m taking it your single? (no spouse to take advantage of a Roth IRA, too?)

      Even with no match and hoping the 401k options aren’t absolutely horrible, then the 401k will be the next logical step. Does your company have a Roth 401k option? Something else you might want to consider.

  12. Kathrine says

    Seems to me that we should be educating people on how to invest/pick funds in their 401k so they get the most of their investment and get the match rather than telling them to stop contributing and switch to the Roth. Even on a bad year, the return on what I contribute in my 401k is decent because of the match.

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