Last week, we explored the basics of baby steps 1 and 2 — save up $1,000 in a beginning Emergency Fund, and pay off all non-mortgage debt. Today, we’ll explore Dave Ramsey’s baby steps 3, 4, and 5.
To recap, the “baby steps” are:
1. Quickly save $1,000 as your beginning Emergency Fund.
2. Pay off all your non-mortgage debt using the Debt Snowball method.
3. Save 3 to 6 months of expenses, completing the Emergency Fund from step 1.
4. Invest 15% of your regular household income for retirement.
5. Create a college fund for your children.
6. Pay off your house.
7. Build wealth and give like crazy.
Our steps today are to save 3 to 6 months of expenses, to invest 15 percent in retirement, and to create a college fund for your kids. These steps can be incredibly intimidating, but they don’t have to be — they simply take some research and education.
Again, let me remind you that Dave’s plan isn’t the only plan, but it’s a great one that makes a lot of sense, and has worked beautifully for my family.
And also, even though “give like crazy” isn’t until step 7, he still advocates charitable giving all throughout the plan. The last step implies having enough wealth that you can give tons of it away and still live comfortably.
Baby Step 3
Photo by it’s about life
Remember that $1,000 you socked away in baby step 1? Now that you’re debt-free (baby step 2), it’s time to fully fund that Emergency Fund with 3 to 6 months of living expenses.
It might sound difficult, but now that you’re debt-free, you can simply transfer all the money you were sending to someone else, and now pay yourself. Don’t raise your standard of living, and finishing your Emergency Fund won’t take as long as you think.
We thought ours would take at least nine months, and it only took four.
It really feels good to keep that money you were just recently sending to your debtors. Yes, you can probably go out to eat once a week now, but because it’s so much fun to watch that number grow in your Emergency Fund, you’ll be surprised at how much you’d rather store your cash away for later.
Note that you need to save 3 to 6 months of living expenses, not income. Calculate your magic number by tallying up just what you’d need in an emergency — mortgage, utilities, groceries, and the like.
And I’d recommend veering more to the six months side of things, in today’s economy.
Extra Baby Steps 3
Somewhere between baby steps 3 and 4 is the best time to save for your extra needs. So if you need to sock away for a car replacement fund, a down payment, or even a vacation to celebrate your recent financial milestones, go right ahead. I save up for these sinking funds in a myriad of ING Savings Accounts. Read more about how we use ING to separate our savings goals.
Baby Step 4
Photo by Alex Proimos
Now that you’ve got a fully funded Emergency Fund, it’s time to bring that retirement savings back up. Dave recommends stopping retirement while you work baby steps 1 through 3, mostly to have as much extra cash as possible to finish the steps. It’ll also light that fire under you, making you as gazelle intense as possible.
Saving for retirement is the most important investment you can make, because no one else can do it for you. If you’d like to live out your golden years with dignity, then you shouldn’t rely on your children, and certainly not the government.
Every specific plan is different, depending on your citizenship. For my fellow Americans, Dave recommends the following:
3. If you max out your tax-free contributions and still have money to invest, put the rest in your pre-tax savings plan.
There are definitely some arguments about why Dave recommends specifically 15 percent. I don’t want to get into them today. But I will say that overall, 15 is a good average — if you’re starting late, you might want to shoot for 20 percent; if you’re still in your teens, you’re probably fine with 10 for now.
Baby Step 5
Photo by Kevin Rawlings
You can start baby steps 4 and 5 at the same time. Step 5 is to save for your kids’ college education. This is an important step (though not as important as baby step 4, in my opinion), and if you’d like to give your children a fighting shot at attending university debt-free, a great gift would be some funds socked away, just for this purpose.
Dave recommends (if you’re American) using a Coverdell Education Savings Account (ESA) for your contributions. You can contribute up to $2,000 per year in each account (one per child), and the ESA grows tax-free until withdrawn.
And then, according to the IRS website, “Distributions are tax-free as long as they are used for qualified education expenses, such as tuition and fees, required books, supplies and equipment and qualified expenses for room and board.”
What about 529 plans?
Saving for college via a 529 plan has its advantages as well, and you can open both a 529 and an ESA. The qualifying statement, however, is that each state has its own 529 plan, and they’re all different. So it’s pretty hard to make a blanket statement declaring all 529s to be problem-free. Do your research before proceeding.
You can chat with an investment professional if you’re interested in a 529 — Dave has a database of his Endorsed Local Providers (ELPs) on his site. Find one in your area.
Also, Cash Money Life has a good post recapping the similarities and differences between ESAs and 529s.
Dave almost always advocates doing all this investing via growth stock mutual funds. This, too, is sometimes controversial, but if you’re in it for the long haul, mutual funds are safe and have a decent return.
Don’t be scared by today’s economy, and don’t make rash decisions. Remember, investing is for the long-haul. Look at returns of at least seven years or longer.
If you’re still getting out of debt, finish that snowball before investing or saving more than $1,000 for small emergencies.
• Once you have 3 to 6 months of expenses saved up, actively research and begin your best investment options. It’s never too late (or too early) to invest.
• Stick with low-risk investments in trusted sources, such as those listed above. Don’t trust get rich quick schemes.
• Above all, educate yourself. Don’t blindly assume the advice of anyone — even Dave Ramsey. Acquire financial wisdom and knowledge, and don’t be scared. If you have questions, seek out the answers.
Next Monday, we’ll discuss the last two baby steps — pay off your house, build wealth, and give like crazy.
Any thoughts? Questions? How scary is investing to you?