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”, 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.