Dave Ramsey Epic Fail: IRA Tax Savings!

This morning I heard a Dave Ramsey moment on the radio. Dave said that a fully funded IRA, after 20 some odd years would amount to some $9 million. Ok, that's fine. We can assume the stock market never crashes and you earn Dave's token 10% rate for enough years to accumulate $9 million. That's not what I had a problem with. Every finance guy likes to tout his latest variable as if it is a fixed number.

Dave then went on to tell us that if it was a normal IRA it would all be taxable, but if it was a Roth it would be tax free! What a miracle! WHAT A LIE!

Let's compare the two. I'll make it super simple. Let's assume we invest $100 for one year and it earns Dave's famous 10%. That means at the end of the year we'd have $110. What Dave said was that if it was a traditional IRA we would owe taxes. Assuming 30% tax rate, that means $77 would be ours. However, if we had used a roth IRA it would be $110 tax free.

Where Dave EPICLY FAILS, is the assumption that we would have the same amount of money to invest in a Roth and as a Traditional IRA. Truthfully, if we had invested the $100 in a Roth IRA, that means we paid taxes on the money in the year that we contributed it. Essentially, we would have contributed $70 and paid $30 in taxes, assuming our 30% tax rate. After our year of magic 10% Dave earnings, we would have... *drum roll please* $77.

Just to recap: Traditional IRA $77, Roth IRA $77. Uh, Dave? Roth and traditional IRA are NET TAX NEUTRAL!!! Even if we still contributed the max to either account they have different maximum allowed contributions to accommodate this. Uncle Sam has to get his and ROTH vs TRADITION ARE NET TAX NEUTRAL!!!

The real questions for Roth vs Traditional are; will you be in a higher tax bracket now or later? Do you expect tax rates to be higher now or later? Do you want to owe taxes to the government or pay your tax debt now?

I'm a fan of the Roth IRA, but as I've said many times before; the real problem Dave has is that there is no one size fit's all answer.

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Why Dave Ramsey is an Epic Fail: Distribution Strategy

If you love Dave, great. He helps a lot of people. He is amazing at helping people get out of debt, but he is not an investment advisor. He is not a financial strategist. He is a salesman and an entertainer. I too love Dave for helping a lot of people, but it is important to know ard realize that he is not a one size fits all answer. The Following is a very common scenario implementing Dave's strategy.

            If someone needed $50,000 a year in order to retire, and they think they can get a 10% return, then theoretically they will need to have $500,000 in order to retire. This is a modest living, but possible. If they retire in1998, and they didn’t make any withdrawals until the end of each year, then their account balance would look like this.

Year	Return (%)	Return ($)	Withdrawal	Balance
1997			$           -	$  500,000
1998	29%	$  143,650	$    50,000	$  593,650
1999	21%	$  125,320	$    50,000	$  668,970
2000	-9%	$   (60,943)	$    50,000	$  558,026
2001	-12%	$   (66,852)	$    50,000	$  441,175
2002	-22%	$   (98,250)	$    50,000	$  292,925
2003	29%	$    84,128	$    50,000	$  327,053
2004	11%	$    35,387	$    50,000	$  312,440
2005	5%	$    14,966	$    50,000	$  277,406
2006	16%	$    43,664	$    50,000	$  271,070
2007	5%	$    14,800	$    50,000	$  235,871
2008	-37%	$   (87,791)	$    50,000	$    98,080
2009	27%	$    26,589	$    50,000	$    74,669

            They did great when the market did great. Their account balance even grew when they were taking out their needed income. But as you notice their balance goes from $500,000 to $74,669 over the course of ten years. They are likely to run out of money in the next year or two. Most of us plan on being retired for longer than 10 years. If this person retired at age 65 they would run out of money by age 76 or 77. When someone runs out of retirement funds they often are not in the condition to work which leaves them two options; move in with family, or live in extreme poverty. Yes there is Social Security and Medicaid and Medicare for now, but that is never ideal nor desirable.

            You may ask, “What happened? Why didn’t it work?” The simple answer in this case is timing. The market doesn’t just go one way. It goes up, down, and sideways. This person only makes money on up years, and they still have to withdrawal money when they haven’t made any. This person just didn’t time his retirement right. It’s not an easy thing to do.

            The root of the problem is the assumptions of needs based planning that the market will always go up on an average 10%. That assumption allows people to plan on living off their interest rate, or their returns each year. However, when their return is not enough, they will likely not be able to reduce their expenses sufficiently. The result is a withdrawal of the basis, or the amount from which they earn returns used to pay living expenses. This means that the amount of returns they will receive from year to year will be less. Essentially their retirement income will be less. Unless they decrease their expenses to match their decreased income the result will be fatal.

There is no "one stop shop" for financial survival. Our financial world is constantly changing. All we can do is educate ourselves and hold on for the ride; be smart and thrive.

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