What Dave Ramsey Gets Wrong

Dave Ramsey has helped countless people get out of debt and build wealth through home ownership and contributions to retirement accounts. For the most part his advice is sound. However, he is wrong about at least one thing: he instructs his listeners to prioritize Roth retirement accounts over their Traditional counterparts, a mistake.

I have long heard Dave recommend Roth accounts over Traditional and wondered about his reasoning. Roth does have advantages: the ability to withdraw the principal contributed prior to retirement without penalty, the ability to effectively contribute more money per year by maxing out the Roth limits as opposed to Traditional [1], and the flexibility that comes with lack of RMDs. These are nice perks, and Dave is aware of all of them. But this is not his rationale for preferring Roth, and it is not where he goes wrong.

It wasn't until this past weekend, when a new Dave Ramsey YouTube clip came out, that I got my answer.

In the video Dave explains that investors would be best served by contributing all of their retirement savings to Roth accounts because you end up paying significantly less taxes this way. He goes on to give a hypothetical example where you contribute $96,000 to a retirement account and it grows to $2,500,000 over the course of your working career. In this scenario, if you put the $96K in a Roth you would pay taxes on $96K, and if you put the $96K in a Traditional account you would pay taxes on $2.5M. Ramsey thus concludes that you pay way more taxes with Traditional and therefore Roth clearly wins.

This is all well and good. The only problem is he's optimizing for the wrong thing; you aren't trying to minimize the amount of taxes paid, you're trying to maximize the amount of money you have left over after taxes are paid. You might think these goals are equivalent, but they're not.

To understand why, let's reduce the problem down to a simple equation with three variables:

Spendable Retirement Savings = $ Contributed * Investment Return Multiplier * Tax Multiplier

To clarify the intent of these variables let's input some numbers; plugging in the numbers from Dave's example, and assuming a 30% tax rate, we get:

Spendable Retirement Savings = $96,000 * ~26 * 0.7

Spendable Retirement Savings is what we want to maximize. Assuming your $ Contributed and Investment Return Multiplier are both fixed, the only variable left in the Roth vs. Traditional comparison is the Tax Multiplier. But if your tax brackets are the same in retirement as they are in your working years the Tax Multiplier remains constant as well. The only difference is whether the Tax Multiplier is applied at the beginning of the equation (Roth) or at the end (Traditional). Since order of operations doesn't matter in multiplication, the end result is identical either way. Paying taxes after the 26X investment return multiplier is applied (Traditional) does indeed result in more taxes paid compared to paying taxes before the multiplier is applied (Roth), but the amount of money you have leftover after taxes is identical in either case.

The key insight is that although you unquestionably pay more in terms of $ in taxes with a Traditional, you are paying these taxes much later at the time of retirement; due to the time-value of money they're much less valuable than taxes paid now. The real variable to minimize is the % taxes paid as this will maximize the leftover $ available for spending in retirement. To minimize % taxes paid you need to minimize your effective tax rate, which means staying in as low of tax brackets as possible during both working and retirement years.

The ideal scenario is to spread out your taxable income evenly over every year of your life. This is of course impossible as earning the same amount starting out at 18 as you make as a 50-something well established in a career isn't going to happen. But the goal should be to flatten out your taxable income as much as possible. This is achieved by utilizing Roth in lower-income years and Traditional in higher-income years, not by using Roth alone.

If you were to take Dave's advice and invest only in Roth accounts during your working career, with no investments outside of retirement accounts, you would have zero taxable income for what could be a 30-year retirement, thus foregoing these low tax brackets in favor of the highest brackets during your peak working years. Given that employer matches are always Traditional, and many employers don't offer a Roth retirement plan, the reality of following Dave's advice wouldn't be nearly this stark. [2] But we're still talking about significantly reduced retirement savings for many workers.

[1] When you contribute the IRA maximum contribution limit of $6,500 (2023 tax year limit) to a Roth IRA, you are effectively contributing more due to the extra money being paid in taxes up front; you would have to contribute more than $6,500 to a Traditional IRA to effectively make an equal contribution, but this is not allowed since you are confined to the $6,500 limit in either case.

[2] Part of social security also becomes taxable once you exceed certain income thresholds in retirement. If the distributions from your Traditional accounts pushed you beyond these thresholds, part of your social security benefits would be included as taxable income in retirement as well, further lessening the negative impact of the all-Roth approach.