Baby Step 4: Invest 15% for retirement [podcast]

Podcast: Play in new window | Download

Dave Ramsey’s 4th Baby Step is to invest 15% for retirement. We are halfway through a complete Total Money Makeover and the rest is pretty easy.

First let’s review the previous 3 Baby Steps:

1. Make the choice to get out of the debt business by building a $1,000 emergency fund and stop borrowing money
2. Pay off all consumer/non-mortgage debt using the Debt Snowball Method
3. Build your emergency savings to 3-6 months of expenses and celebrate

The biggest changes after completing Baby Step 3

While working on Baby Steps 1, 2, and 3 we are to spend all our energy, income, and attention on only one of the steps at a time. All of our focus and intensity went to finishing each of the previous stages. Now we can let off the gas a little. Certain budget categories can be increased to pre-get-out-of-debt levels like eating out or vacations. However, it would be irresponsible to blow all of our income after working so hard to pay off the debt – so we need to start investing.

What else is different? When we enter into Baby Step 4 we will begin doing other things at the same time. Not only will we be investing 15% for retirement but we have the opportunity to increase giving, spending more on ourselves, and saving up for other purchases. You will also be able to do Baby Steps 4, 5, and 6 all at once.

Baby Step 4: The Easiest Baby Step

Why not less? First of all, saving 15% is really easy to do. The average American’s budget is crippled by 20% – 35% of  take-home pay just for debt repayment. Think about it: A household maintaining three credit cards with balances and two new vehicles will spend at least $1,200 making minimum payments. That’s 20% of a $6,000 a month take-home pay! Add any other debts you may have been paying before you got out of debt and you will realize that saving 15% for retirement isn’t as hard as it looks.

Why not more than 15%? You certainly could choose to put more into retirement but for 15% is plenty. It will allow you to do more things as we will describe in the next two Baby Steps.

How employees with company sponsored plans save 15%

If you work for a company that has a retirement program then you have it easier than anyone else. Simply ask your Benefits department or person in charge to increase your 401k contributions to 15% of your pay. You can sock away up to $17,500 in that puppy each year – and that doesn’t include any matching contributions your company might give you. Employees 50 years or older are allowed to save an additional $5,500 a year in what is called “Catch-up Contributions”.

It’s OK if there’s no 401k

For those who don’t have a 401k plan at work, are self employed, or just want better investing options and tax-free growth there are plenty of options to choose from. I won’t go into all of them – there are just too many to name – but people who have an earned income can save for retirement inside Individual Retirement Arrangements. These are most commonly referred to as IRAs.

The two most common IRAs are Traditional and Roth IRAs. Both give you thousands of investing options. Both give you tax savings. Both cause you to have more money at retirement than just relying on Social Security.

Traditional IRAs save you income taxes today and allow your retirement investments to grow tax-deferred. That means you will not pay taxes on the money before it’s put in or while it is growing. However, you will pay taxes when you take money out at retirement.

Roth IRAs don’t give you any tax relief today but will save you tons at retirement. That is because the government has already taxed the money you put in – they can’t tax it again! And the IRS code allows the earnings and the distributions you take out to be tax-free. I call this “paying for the seed and not for the tree” investing.

The Best of Both Worlds

You could entertain the idea of doing both employer sponsored plans and an IRA so long as contributions do not reach the income limits of the household. Here is an example:

An individual can choose to save up to the employer match in their work’s 401k and then do the rest in a Roth IRA. The limit on how much you can put into the Roth is $5,500. If you’ve done both and still haven’t reached your 15% into retirement goal then consider going back to your 401k and finish up there.

For example: An individual earning $100,000 a year with a 3% match at work could save 3% at work ($3,000), put $5,500 into a Roth, and still have $6,500 to put somewhere. Raising the 401k up to 9.5% gives you the benefits of all three worlds: Company match with the 401k, tax-free growth in the Roth IRA, and additional income tax relief from more going into the 401k.

A married couple can also open a Roth for a spouse that does not have an earned income. This could also help shelter tax-free growth and get you to meeting that magic 15% recommendation.

Note: Invest 15% of your household income regardless of your company’s match. If you save too much money then you could take your children and grandkids on a Disney cruise.

What about other investment options?

Because we are concentrating 15% of our gross income on retirement savings we must focus on good retirement investment options. It would be foolish to invest in a bunch of funds that do not perform well or are  high in fees. This is where talking to a Financial Planner comes in handy.

While I am not a Financial Planner, I do recommend diversification. That means spreading your savings into at least four mutual funds, maybe even more, in different sectors of the market. Large Cap, Small Cap, Mid Cap, and International mutual funds are a great start.

What about other investment options? but you may want to try other things. However, investing in other assets like real estate or individual stocks could be included in a future baby step. For now: Relax, take 15% off the top, and save your attention for the next post.