Baby Step Four: How do I invest for retirement?

Baby Step Four

We are just now starting baby step four of Dave Ramsey’s Baby Steps.  In this step, you start saving 15% of your income towards retirement.  This highlights one of the things I really like about Dave Ramsey’s plan.  His plan is focused on long-term financial success.  And saving for something that is still 30 years away (for some) definitely requires some patience and planning.  It reminds me of a book I am reading called Grit.  In this book, the author highlights the importance of sticking to a goal or ideal, and ultimately achieving it.  I believe anyone who follows completely through Dave Ramsey’s plan must have some grit (passion and perseverance).  With that said, this blog post goes into detail about how we will start really saving toward retirement.

Household Income

The first step toward working on Baby Step Four is determining your yearly household income.  For most, this should be easy.  This should not include bonuses or other income that is not guaranteed.  If your income fluctuates a lot from month to month, then you could use last year’s income with some percentage added to it if your income increases from year to year.  For us, this number is pretty straightforward:

Household Income = $130,000 / year

Note: This is our actual household income.  We do not buy into the American philosophy that you have to keep your finances private from the world.  I like to learn from what others are doing and do not feel jealous if someone makes more money than we do.

15% of Household Income

Once you know your household income, the next step is simple.  Multiply that number by 15%:

$130,000 / year * 0.15 = $19,500 / year

This number, 15% of your yearly household income, is the most important number in this equation.  This number is the amount you want to put into retirement each year.  Keep in mind that even if your company does an employer match on your 401k, as mine does, that is not part of the equation.  The money your employer contributes is just icing on the cake.  You, yourself still need to contribute a full 15%.

Which type of retirement account should I use?

Now that you know how much money to put toward retirement, the next question is: Where do I put my money?  There are so many choices, between traditional 401k plans, Roth IRAs, traditional IRAs, etc.  If your company offers an employer match, then the question of where to start is easy.  In other words, if your company is offering you free money, then take it!

Generally speaking, Dave suggests that you first contribute enough money to meet the company match, then you max out both you and your spouses Roth IRAs, and then if you still have room to contribute more, then you contribute more to your 401k.  That can all seem pretty confusing at first, so here is an example of what we are going to start doing (today) with our own finances:

  1. 401k contribution to meet company match of 3%: $3,900
  2. Max out Roth IRA: $5,500
  3. Max out spouse Roth IRA: $5,500
  4. 401k additional contribution amount: $4,600

So, how did I come to those exact contribution amounts?  The first 401k contribution amount is simply 3% of my yearly income, since that is what my employer requires that I contribute to get a 3% company mach from them.  The Roth IRA contribution amounts are the maximum amounts you can contribute to a Roth IRA in a single year.  Then, the additional 401k contribution amount was calculated by subtracting the previous contribution amounts from the total amount we are trying to contribute for the year: $19500 – ($3900 + $5500 + $5500) = $4600.

The important part, is that if I now add up all contributions (1-4) above, we reach our 15% goal in a tax effective way:

$3,900 + $5,500 + $5,500 + $4,600 = $19,500 total contributions / year

How to make the contributions?

For the 401k contributions at work, I can simply fill out an electronic form at work to modify the percentage of my income that I am contributing.  Then it will be automatically taking out of my paycheck before I even see it.  From above, we know that I need to contribute $3,900 + $4,600 = $8,500, to my 401k.  What percentage of my income is that?  If you remember your algebra, the equation would be: contribution / income * 100 = contribution-percentage.  For us that would be:

$8,500 / $130,000 * 100 = 6.5% 401k contribution

To maximize our Roth IRA contribution, we just need to figure out how much of our monthly budget will go toward the Roth IRA to reach our yearly goal of $11,000 ($5,500 each).  That again is pretty straightforward:

$11,000 / 12 = $916.67 / month to Roth IRAs

Which types of funds to invest in?

Dave suggests investing equally in the following types of funds: “growth, aggressive growth, growth and income, and international”.  Personally, I’m not really sure what this means.  So, I am going to at least start putting the money in the appropriate 401k and Roth IRA accounts.  At that point, I’ll select funds from the 4 categories above.

Summary

In summary, by making these two lifestyle changes 1) increasing our 401k contribution to 6.5% and 2) contributing $916.67 / month toward our Roth IRAs, we will be saving 15% of our income toward retirement.  The best part about this, is that the Roth IRA money will grow tax free for many years, and we will not have to pay taxes on the growth, since we paid taxes on the money before it went into the Roth IRA.  My wife and I already happen to own very small Roth IRA accounts, so there is no need for us to open new accounts.  Time to modify my 401k contribution percentage at work to start making this baby step a reality!

On to the next Baby Step!

Now that I have increased my 401 contribution and updated my Everydollar budget to include the Roth IRA contribution, Baby Step 4 is all set!  The retirement company at my work only allows whole numbers for retirement contribution percentages, so, I increased the 6.5% to 7%.  Keep in mind, baby step 4 is meant to be an on-going contribution that is done concurrently with baby steps 5 and 6.  While we are ready to start baby step 5, we are going to wait a little bit, since my wife has some home projects that she would like to do (laminate flooring and building an outdoor shed).  However, now, in between baby steps 4 and 5, is a great time to do home projects such as these.  It will only delay baby steps 5 and 6 by a couple of months.