Dave Ramsey's Warning About the IRA Mistake That Could Cost You $400,000 in Retirement

Workers have many choices when it comes to saving for retirement. There are several types of accounts, and it can be confusing trying to understand which may be best for your retirement goals.

Dave Ramsey, a personal finance expert, best-selling author, and founder of Ramsey Solutions, explains that the type of IRA account people choose could have a big impact on how much tax they pay in retirement. Here is more information about the differences between a Roth and a Traditional IRA, which one Ramsey prefers, and why.

Roth vs. Traditional IRAs: Paying taxes now or later

The one key difference between a Roth and a traditional IRA is whether or not you pay taxes today or during retirement. With a Roth IRA, you contribute money with after-tax income. That means that in retirement, if you meet all the qualifications, you can withdraw money tax-free.

A traditional IRA, on the other hand, allows you to contribute with pretax income, which can lower your taxable income and save you money on taxes in the present day. However, during retirement, when you withdraw money from the account, you'll have to pay taxes on it then.

Ramsey's $1.7 million example

Dave Ramsey has stated many times that he prefers Roth IRAs for the tax benefits in retirement. Recently, on the Ramsey show, a 33-year-old called to ask which type of IRA was better. Ramsey explained that if he contributed $500 per month for 30 years at 12% interest, he would end up with approximately $1.7 million. If that money were in a traditional IRA, he would have a tax bill of hundreds of thousands of dollars. If that money were in a Roth IRA, he would not have to pay any taxes on it at all.

Traditional vs. Roth IRAs RMD requirements

Another key benefit of a Roth IRA is that there are no required minimum distributions (RMDs). That means that people can leave their investments in Roth IRAs for as long as they want. Traditional IRAs, on the other hand, require investors to make a withdrawal at age 73, even if retirees don't need the income at the time. These withdrawals, depending on their size, may cause people to move into a higher tax bracket, meaning they may owe more in taxes.

The best time to complete a Roth conversion

It's possible to convert your traditional retirement account into a Roth account to take advantage of the tax savings in retirement, but timing matters. Ramsey explains that if you are retiring in five years or less, converting to a Roth account doesn't make sense. However, if retirement is more than five years away, it may be worthwhile.

The decision may come down to your tax bracket

Some people know that when they're in retirement and living on a fixed income, they will be in a lower tax bracket. However, that's not the case for all retirees. Some retirees live on less throughout their working years and end up having a higher income in retirement. Some retirees may own real estate or businesses that have increasing income as they age.

Income taxes may not impact those in a lower tax bracket as heavily as those who expect to be in a higher tax bracket in retirement. Take this into account when deciding which type of IRA account to invest in.

What to do before choosing an IRA

Currently, you have to make under $153,000 a year as an individual or $242,000 or less as a joint filer to be able to contribute to a Roth IRA, without having to take extra steps to complete a backdoor Roth IRA.

Some people at the higher end of that income range use traditional IRAs to lower their taxable income in the current tax year. There are pros and cons to both options, and if you're not sure which is best for you, your personal finances, and your retirement goals, ask a financial advisor for help.

Ramsey's tips for transitioning into retirement

Ramsey recommends being debt-free before retirement. Ideally, he recommends being mortgage-free before you retire. That's because having debt payments can negatively impact your cash flow in retirement.

When you're living on a fixed income, having extra payments adds financial stress. In addition to being debt-free, Ramsey recommends having a three to six-month emergency fund. This is especially helpful for retirement, so you don't have to withdraw from your retirement accounts to pay for an emergency, especially in a down market.

Bottom line

When making a retirement plan, it's important to consider more than just how much you're able to contribute each year. In fact, Ramsey explains that the type of retirement accounts people choose can dramatically impact their taxes in retirement. If you're not sure whether or not you're optimizing your contributions to be tax efficient in the future, work with a financial advisor who can give you advice about the best steps to take for you.