Dave Ramsey’s Baby Step 4: Invest 15% for Retirement

by Joe Plemon on October 20, 2009

Congratulations! You have done lots of hard work and have demonstrated great discipline in the process of Dave Ramsey’s Baby Steps. First, you saved $1,000 in a small emergency fund (Step 1), which gave you a buffer against life while you strategically paid off all debt except your house (Step 2) using the debt snowball. With your debt gone, you were able to use that cash flow that had been going toward debt reduction to build up 3-6 months of expenses in your fully funded emergency fund (Step 3). You are debt free with a healthy safety net. But now is not the time to relax. In fact, this is when things start getting fun. It is time for Baby Step 4 : investing 15% of your household income into Roth IRAs and pre-tax retirement plans.

Why 15%?

“Why”, you ask, “does Dave recommend 15%?” Good question! Baby step 5 (college funding) and 6 (pay off house early) give us the answer and help us understand why all of these steps work together.

First, 15% is doable because you have already created the great cash flow in the previous steps. And 15% is an amount that, in most scenarios, will create a nest egg sufficient for retirement with dignity. So the question becomes, “What if I want to contribute more than 15% or less than 15%?” The problem with contributing more than 15% is that you are shortchanging your other financial goals: namely college funding and paying off your house. Dave’s plan is for you to not only build up your retirement fund, but also help with college funding (if applicable) and get that house paid off early.

On the other hand, if you decide to contribute less than 15% for your retirement because you want to help with Junior’s college or pay extra on your house, you are risking your retirement. That paid for college diploma will not put food on your table when you retire. And being 75 years old with a paid for house and no money is not a cheerful prospect.

What Kinds of Investments Does Dave Recommend?

This discussion has two components: the tax treatment and the actual type of funds you invest in. First, the tax treatment. Dave loves the Roth IRA because you pay your taxes upfront and then allow the fund to grow tax free. Yes, ALL of the growth is tax free, meaning when you draw the money out at retirement, you pay ZERO taxes. So why does Dave put the 401(k) ahead of the Roth? Simple: the employer match is free money. The plan is to get all the free money you can get, then invest in Roth IRAs. If you max out the allowable Roth investment ($5,000 in 2009 for those under age 50), you then go back to the 401(k) until you hit 15%.

Example: Jim earns $100,000 annual income. His employer will fully match up to 5% of his 401(k) investment, so Jim, in order to get that full match, will invest $5,000 into his 401(k). He then moves to the Roth IRA and maxes it out at $5,000. His total investment is now $10,000 (10% of his income) so he goes back to the 401(k) for another $5,000 with will bring him up to a total of 15%. Note that you don’t use the 401(k) match as part of the 15% … this percent should all come from your income.

Simply put, it looks like this:

  • First investment: 401(k) up to full match
  • Second investment: Open a Roth IRA and contribute until it is maxed out.
  • Third investment: Back to the 401(k) until you reach 15% of your income.

What Types of Funds Does Dave Recommend?

Because Dave loves both diversification and mutual funds, he recommends a diversification of mutual funds. He does not make specific fund recommendations, but does recommend the following mix of mutual funds:

  • 25% Growth
  • 25% Growth and Income
  • 25% Aggressive Growth
  • 25% International

Dave recommends only mutual funds that have at least a 5 year track record, and preferably 15 or more years of positive performance.

So How Does This Play Out?

With the recent craziness in the world of investments, some say we shouldn’t be putting money in the stock market. Admittedly, there is cause for concern. But what choices do we have? Dave points out that unless we believe that all of the major companies in our nation are going to fail, we are wise to continue to invest.

Our hypothetical couple, Bill and Karn, are both 35 years old and make a combined $60,000 income. Their 15% investment would be $9,000 annually. A 10% annual return would give them a nest egg of about $1.7 million at age 65. If they drew 4% annually from the nest egg, their retirement income would be $68,000 annually. This number is not adjusted for inflation, but we also didn’t adjust their increased contributions as their incomes increased over the years. With no debt and a paid for house, they should do all right at retirement, especially if Social Security is still around.


{ 5 comments… read them below or add one }

Joe Plemon October 24, 2009 at 9:16 pm


It sounds like we are splitting hairs about this 15%, but Dave says in Chapter 9 of his book The Total Money Makeover, “When calculating the 15%, don’t include company matches in your plan. Invest 15% of your gross income. If your company matches some or part of your contribution, you can consider it gravy. ”

But either way, if you consistently invest, you are doing more to prepare for retirement than the vast majority of our society.

Thanks for reading. I appreciate your thoughts.


Damon Day October 28, 2009 at 11:28 am

Good Post Joe,

What I like about Dave’s approach is that it is typically very simple and straightforward. Almost everyone can do it, it is just a matter of getting started. Consumer Debt is the cancer that typically must be dealt with first. After that, most people find that the freed up cash flow from not having to make credit card payments, is sufficient enough to start saving for retirement, college, and early pay o ff of the mortgage.


Joe Plemon October 28, 2009 at 11:50 am

You’ve got it Damon. Dave is the king of behavioral finance…meaning it is not high tech, but simple, understandable and do-able. And millions can attest that it works.

Thanks for your thoughts. I always appreciate what you have to say.


threadbndr November 12, 2009 at 2:26 pm

It sounds tough to get to 15%, but if you start with just the 5 or 6% to get the company match and gradually increase your contributions to the Roth over a year or so, it’s very do-able.

My rule of thumb is that every raise I get – half goes into increasing the retirement savings % and half to the checkbook (or preferably current saving for vacation, house projects, etc). That keeps the lifestyle inflation under control.

Good overview.


joeplemon June 23, 2010 at 2:19 pm

Obviously, me too! Thanks for stopping by.


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