In previous posts we we have talked about the first three of Dave Ramsey’s Baby Steps. First, we need to save $1,000 as a starter emergency fund. Then Baby step 2 is the debt snowball to pay off all debts but our house. Then Baby Step 3 we extend that $1000 out into a real 3-6 months emergency fund.
At this point we are stable financially. Our only debt is possibly a mortgage. We have several mon
ths of expenses sitting in savings. Now what?
It is very important that we do the first three baby steps in order. There is great power in focus. Many times people fail to reach their goals because they are trying to do to many things at once. However now that those are completed you can actually tackle Baby Steps 4, 5 and 6 at the same time. Baby Step 4 is saving 15% of your income for retirement. Baby Step 5 is saving for our children’s college. Baby Step 6 is paying off that mortgage. All three of these are longer term goals we will accomplish over many years, so we can attack these three simultaneously.
Today we’ll talk about Baby Step 4.
Once we have our fully funded emergency fund in place, we need to turn our attention to saving for retirement. In Baby Step 4 we should be saving 15% of our income into retirement.
Why 15%?
Saving 15% will allow us to make good progress on our savings goals.
Let’s say we are debt free at age 30 and we have a household income of $40,000, the national average. 15% of that would be about $500 a month. If we invested that from the age of 30 to the age of 65 and made 8% over those years we would have $1,154,586.86 in our retirement account. In actuality over its lifetime the market has earned close to 12%. If we were getting 12% then that total jumps to $3,247,632.22. This is also assuming our income never improved over that entire 35 years, but we would hope somewhere over that time we’ll see a few raises, so these numbers are really pretty conservative. Most of us would feel pretty good if we were retiring with over a million dollars.
If 15% is good then why not more?
We still need to be making progress on Baby Steps 5 and 6. Plus, at this point in the baby steps you want to make sure you take time to enjoy life a little from time to time. In addition there are day-to-day expenses you need to be saving for. You need to be saving to a car replacement fund, so that when your current vehicle wears out you can pay cash and not land back in debt. You need to be saving for the basic home maintenance that is going to be needed from time to time. Save to pay cash for a vacation occasionally.
All those other goals are going to be difficult to accomplish if you are saving 20-30% for retirement. Plus as you get farther along the road, you’ll have gotten some raises and will be making more. College is taken care of. The home is paid off. Then you can always increase your retirement savings as much as you are able if you desire.
Where should I save?
OK. So I’m ready to start saving. Now what?
The two best long-term modes of investing are the stock market and paid for real estate. These investments are for the long-term. You have to make sure you are taking enough risk with your investment that you are able to stay ahead of inflation and taxes. At the same time you want to be well diversified. That just means your money is spread over a large variety of investments. A great, simple way of accomplishing this is through the use of mutual funds. Mutual funds allow your money to be spread out over hundreds of companies in a variety of locations and industries. This protects you from the Enron’s of the world and will help you with riding out the ups and downs of the market.
How should I save?
Workplace options
First, do you have a workplace retirement savings program available like a 401K or 403B? Do they offer a company match? Many companies do and this is like free money. You should almost always at least invest up to whatever percentage they match. Let’s say your company matches 50 cents on the dollar for the first 8% that you put in. You should put in at least 8% in your company program. This is like getting a 50% return on your investment before you even start.
In addition, investments in these types of accounts are usually pre-tax. That means any money invested comes out before taxes are calculated, lowering your overall taxable income. Let’s say you are in a 25% tax bracket. In effect, what that means is that in addition to your company match, the government is matching you an additional 25%. The combination of the two are pretty hard to beat.
You need to look at what the investment options are within this account. Some provide better options than others, but the options would need to be pretty bad before it would be wise to pass on the value of the company match.
Roth IRA
Once you have gotten all of the company match you can, or if you don’t have workplace retirement saving options, the Roth IRA is a great place to turn next. What is a Roth IRA? The difference between a Roth and a traditional IRA or workplace retirement account is that in a Roth you do not get the initial tax savings. These are post-tax dollars. So what is the benefit of a Roth? The cool thing is in a Roth all of the earnings you make over the years are tax-free. So in the example I gave above let’s say your earnings came out some where in the middle and you retired with $2,000,000. If that money were in a Roth, you received no tax benefit over the years on that monthly contribution. Over that 35 years, you would have invested $210,000 and would have paid taxes on $210,000.00. But now that $2,000,000 sitting in your account is 100% tax-free. That’s a pretty good deal.
Not everyone can do a Roth IRA. In 2012 if you are single your ability to contribute is gradually phased out as your income approaches $125,000. If you are married that number is $183,000. Those totals change every year, so you will need to check what is allowed in your situation. For most people, though, the Roth is a nice option.
The other part of the Roth is you are limited in how much you can contribute each year. In 2012 if you are under age 55 you can contribute $5,000 per year. Over 55, you can contribute $6,000. Again these number change every year.
I maxed out my Roth contribution, now what?
If you have invested in your company’s retirement program up to the company match and also invested all you can in a Roth and are still not at your 15% then you can go back to your company’s program to invest the rest.
What if I’m self-employed?
If you are self-employed and therefore don’t have a 401K or 403B option, what alternative do you have? You can create what is known as a SEPP (Simplified Employee Pension Plan). You can accomplish similar goals with a SEPP as you would with a 401K or 403B. I’ll not go into further details on that here. A good financial planner can assist you with setting that up, if you think it would be a good option for your situation.
Seek wise counsel
Most of us do not have time to be an expert in all types of investments. It is wise to seek out a good financial advisor to help you through the maze of options available. The most important key to this is never, ever, ever invest in something you don’t understand. If the advisor you are working with can’t or won’t explain it in such a way that you can understand what and why you are investing where you are investing, then you need to find a different advisor. People lose their life savings when they invest in things they don’t understand only because that’s what someone told them to do. You do not need to be an expert on all investment options, but you do need to make sure you have an advisor that is able to teach you the things you need to know.
Your future up to you
There are clouds around the long-term viability of social security. The days of working at one company for 30 years and then retiring with a gold watch and a pension are almost gone. It is very important that you take responsibility for your future. If those other things come through then that’s great, but you need to have a plan in the event they don’t.
One of the reasons for getting out of debt is it frees up your most powerful wealth building tool: your income. When a good chunk of your income isn’t accounted for before the month even begins, you have the opportunity to be able to save in a way that can radically change your future.
What changes do you need to make today to make sure you can retire with dignity some day?
Photo credit: Millionaire Mindset Secrets