Dave Ramsey From Fruition to Tuition (Class 10 of 13)

In this class Dave Ramsey covers baby step number 4, saving 15% of gross household income in tax favored retirement plans and baby step number 5, save for your children’s college education using tax favored plans. Because Dave Ramsey attempts to cover all possible options available to everyone in all possible employment situations, the result is a little overwhelming and somewhat confusing. Understanding this somewhat arcane subject is further complicated, as the Government is constantly changing the law. As part of his presentation Dave has a telephone ring on stage. He answers it and discovers that once again the law has been changed. In his wrap up he admits that even he is confused and he teaches the stuff. He encourages his listeners to consider this class nothing more than a starting point in their education.

After establishing an emergency fund and paying off all debt except the mortgage, Dave considers planning for retirement the next target on the way to financial peace. He does not believe that anyone should trust the Government to provide for them in their old age. This, I believe, in Dave Ramsey’s mind is as much a statement of principle as an appraisal of our economic future.

Qualified tax favored plans that protect your retirement investments from taxes include, Individual Retirement Arrangements (IRA), Simplified Employee Pension Plans (SEPP), the infamous 401 (k) plans so battered by recent events and late night comedians, 403 (b) plans for hospitals, nonprofits, and the like, 457 plans, and Dave’s favorite the Roth IRA.

The IRA is the oldest of these plans. Basically (as of 2008 when this class was filmed) anyone with an earned income could contribute $5,000 per person to one of these funds. The investor would buy whatever product was placed in the IRA with pretax dollars. That is, the Government did not tax this income. However, the Government will tax the money when it is withdrawn during retirement. The 401 (k) offered by for profit corporations and its cousin the 403 (b) for nonprofit organizations work in a similar manner. The income the employee contributes to the plan is deducted before taxes. Frequently, the employer adds some matching funds in the neighborhood of up to 3% of the employee’s gross income. Typically, the organizations offering these plans offer a limited number of financial products as possible investment choices. For example, the Federal Government Thrift Savings Plan for their employees offers two bond funds and three stock funds. The employee can choose percentages invested in any of these funds or allow the fund managers to select a mix based on age. The 457 plan is a similar type of plan that has some advantages and disadvantages in withdrawals. Dave spends very little time discussing the 457 as it is rare and he doesn’t like it very much. The SEPP is a similar plan that allows the very small businessman the opportunity to shelter up to 15% of his profits in a tax deferred account. However, he must fund a similar percentage to his employees’ accounts as a benefit. Once the company grows beyond a family business it is too expensive to offer as a employment benefit.

Dave Ramsey is a huge proponent of the Roth IRA. This plan allows all but wealthy Americans the option of investing after tax dollars in a wide variety of investment vehicles in a tax free account. In other words, all the capital gains and all the income generated by these investments will not be taxed when used in retirement. Since Dave Ramsey projects 12% return on investments, the difference between, say, $5,000 in pretax income placed in a 401 (k) that 30 years later is taxed as regular income and $4,000 (representing the same number of working hours) in after tax dollars invested in the Roth IRA but generating tax free wealth will be tremendous.

Dave discusses the dangers of early withdrawals from these accounts or loans taken from these accounts. For the purposes of this article, consider all such actions a bad idea. If you are in that desperate a need for money, evaluate your options and their cost with your accountant before proceeding with great care.

In conclusion, for most of his audience, Dave Ramsey suggests the following strategy. Consider a family with a combined annual income of $100,000. Their investment target is $15,000.

Assume they will receive 3% in matching money. The first priority is grabbing the free money.

Place $3,000 in the 401 (k) company adds $3,000

Next place $5,000 each for husband and wife in a Roth IRA (the maximum)

$10,000

Then place the remaining $2,000 in the company 401 (k) without any additional matching dollars.

Baby Step 5, saving for college should only be initiated when 15% of a family’s gross income is going into retirement saving plans. Parents should avoid any guilt trips. Kids will not die if they have to pay for their own education. Scholarships, work study programs, Government grants, and even loans are available for sufficiently motivated students. Such options will not be available to elderly parents.

Like the 401 (k) and its kin, the Education Savings Account (ESA) is available to fund future educational needs with tax sheltered dollars. A wide and growing variety of 529 plans are available in various states. They differ in quality and flexibility. For this reason Dave generally prefers the ESA. Finally, for the very wealthy who are not eligible to contribute to these more common options, states offer Uniform Transfer To Minor Acts (UTMA ) or Uniform Gifts to Minor Acts (UGMA ) that allow the transfer of capital to minors for educational and other purposes. As in other cases, Dave recommends 100% stock mutual funds as a basis for educational investment. He is particularly opposed to the use of whole life policies as a basis for this kind of savings.