Dave Ramsey’s 7 Baby Steps: Step 4 - Invest 15% of Household Income into Roth IRAs and Pre-Tax Retirement Accounts

If you’re the average Total Money Makeover participant, by the time you get to Baby Step 4, you’re two or more years into this journey. Well done! You’ve destroyed your debt, built a solid emergency fund, and are now ready to invest in retirement! Bravo! There are many considerations you should take when getting into investments, so let’s tread carefully here. Again, here are the 7 Baby Steps:

Dave Ramsey’s 7 Baby Steps

• Step 1: Save up $1,000 to start your emergency fund.
• Step 2: Pay off all non-mortgage debt using the debt snowball.
• Step 3: Save up 3 to 6 months of expenses to complete your emergency fund.
• Step 4: Invest 15% of household income into Roth IRAs and pre-tax retirement accounts.
• Step 5: Work on college funding for children.
• Step 6: Pay off your mortgage early.
• Step 7: Build wealth and give!

Aren’t investments risky? Shouldn’t I just save my money?

Some people might be questioning why they should invest in mutual funds. From The Total Money Makeover:

Ibbotson Research says that 97 percent of the five-year periods and 100 percent of the ten-year periods in the stock market’s history have made money.

This is nearly a surefire way to make a return on your money. You can make serious progress in investments. Don’t let the current financial climate get in your way. If times are rough, it is especially opportune to invest!

What’s so magic about 15%?

Dave recommends investing 15% of your household income into good, growth-stock mutual funds that have a 5 to 10 year track record making 12% ROI annually or more. You’ll read in Dave’s book The Total Money Makeover that this percentage is based on many years of working with people on their retirement. 15% of your household income into retirement produces great returns while allowing you to save additional income for the next baby steps (paying off your mortgage and building wealth).

Let’s take a look at the typical scenario:

• Bob invests from age 30 to age 60.
• Bob contributes 15% of his household income into retirement.
• Bob’s annual income is $50,000.
• Bob makes an average annual return of 12% on his money.

Given these factors, Bob would have a little over $2,200,000 upon his retirement at age 60. Not bad! I’m convinced that Bob can do even better if he chooses winning mutual funds, which can be done if he takes the time to research his investments well.

How to diversify amongst mutual funds, that is the question!

Dave breaks up investing your 15% into four major categories of mutual funds amongst which you should contribute equally. They are as follows:

• 25% to Growth and Income (Large Cap or Blue Chip funds)
• 25% to Growth (Mid Cap or Equity funds; an S&P Index fund would also qualify)
• 25% to International (Foreign or Overseas funds)
• 25% to Aggressive Growth (Small Cap or Emerging Market funds)

What are some retirement account options?

You’ve probably heard of Roth IRAs and 401(k)s. But how much of your of your 15% contribution should you put into each? Is one type of retirement account better than another?

Dave recommends a prioritized investment approach - investing your 15% until it runs out down the following accounts:

1. 401(k): If your company has a 401(k) and will match up to a certain percentage, take the match! You can’t beat free money! Let’s say your company matches 3%. Invest 3 percentages of your 15% and move on to the next prioritized account below.
2. Roth IRA: The Roth IRA will allow you to grow your money tax-free since you will have already paid taxes up front. This is a huge advantage. Invest the remainder of your money into Roth IRA’s up to the maximum contribution limit (for example: $5,000 per year). If you still haven’t reached your 15% contribution amount, proceed to the next prioritized account below.
3. 401(k)s, 403(b)s, 457s, or SEPPs (for the self-employed): Take the remaining amount you have and invest back into these types of accounts.

True Retirement: Financial Security

Dave usually makes the point that if you’re looking forward to retirement so you can quit work, you need to find another job! Work should be a life-long endeavor. You can always work and find enjoyment in what you do! Instead of seeking relief from work, seek financial security!

Now that you’re investing 15% of your household income into retirement accounts, it’s time to continue to do so and start thinking about the kids and their college! Join us next time for how you can put your kids through college if you start saving now!

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