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The M-Network is currently doing a series highlighting Dave Ramsey’s 7 Baby Steps for getting out of debt and getting your life on the right track financially. You can read about all of the steps over on Cash Money Life who kicked things off with a great introduction. As other members of the network add their articles, I’ll add links to them at the end of this post.

Dave Ramsey’s Step #4 is simply this–save 15% of your gross income for retirement, preferably in Roth 401(k) and Roth IRA retirement accounts. This step raises two important questions: (1) what’s so special about 15% as opposed to 10%, 20% or some other savings rate; and (2) why invest in after-tax Roth retirement accounts rather than pre-tax 401(k) and IRAs? To answer these questions, I’ve created some charts to show the impact of these decisions on your retirement nest egg. Following the charts, I’ll list some of the factors worth considering as you make your own retirement savings decisions.

Save 15% of Gross Income toward Retirement

Albert Einstein is said to have quipped, “compound interest is the most powerful force in the universe.” Whether he actually said this is undetermined, but to this I would add, “compound interest is the most powerful force in a retirement account.” But to unleash this force you need two things: savings and time. The more savings and time you have, the more powerful the effect of compound interest. So what does the effect of compound interest have on saving 15% of your gross income? Check out this chart showing the growth of 15% savings on a $100,000 per year salary assuming a 10% return, 3.1% inflation and savings beginning at age 30:

There are several important observations to make here. First, the ending balance of just over $2 million is in today’s dollars assuming a 3.1% inflation rate. The actual retirement savings balance after 35 years is over $6 million. Second, notice that the chart is broken into three colors: yellow, blue and purple. The yellow represents the actual amount of money invested, the blue the amount earned directly from the money invested (called simple interest), and purple the amount earned from the simple interest (called compound interest). All of these numbers are adjusted for inflation. But the point is that given enough time, the compound interest earned will far exceed the amount invested or even the simple interest. That’s the most powerful force in the known universe that Einstein was talking about! Finally, note that the $2 million balance in today’s dollars is enough to withdraw about $80,000 a year for retirement, exactly what you’d need if you were seeking to replace 80% of your income in today’s dollars (I’ve written before about the 4% withdraw rate rule for retirement accounts).

No what happens if instead of saving 15%, you save 10%? Here’s the chart:

Notice that you still get the benefit of compounding. That’s because the benefits of compounding depend on how long you invest and what return you earn. But of course, the more you invest, the more you end up with. In this case, at a 10% savings rate, you end up with about $1.3 million in today’s dollars. This is not enough to withdrawal 80% of your current pay during retirement, assuming a 4% withdrawal rate. You may get social security benefits to make up some of this shortfall, but Dave Ramsey’s view is we shouldn’t count on social security. While I’m not as pessimistic on this point as he is, ignoring social security in your retirement assumptions is certainly a conservative approach.

From this we can conclude that a 15% savings rate for retirement is a reasonable approach, given all of the assumptions we’ve made. In making your own decision on retirement savings, you may want to consider these additional factors:

• When you start saving for retirement: If you start saving for retirement at age 18, you may not need to save 15% (although it’s a good habit anyway). At age 18, you have 47 years to invest before you’re 65. At a 10% savings rate using the numbers above, your inflation adjusted balance at age 65 is more than $3 million (more than $13 million in actual dollars!). If you wait until your 40 to begin, you may need to save considerably more than 15%. At that age, a savings rate of 15% yields less than $1 million in inflation adjusted dollars, and even a 20% savings rate results in just under $1.3 million. So when it comes to retirement savings, one of the most critical success factors is to start saving as soon as you can. I should add that if you are in your 40s or older and have little retirement savings, there’s no point in beating yourself up over it. Just start saving now.
• Assuming a 10% return is generous: The above calculations assume a 10% return on investments. Change it to just 9.5% and the numbers drop considerably. Many believe that annual returns of 10% will be unrealistic in years to come. If you’re looking for predictions, you’ve come to the wrong place. But I can say that sticking your money in a money market or “safe” bond account won’t get you the returns most of us need for retirement. I’ve written extensively about asset allocation, and here are to great books that have helped me a lot in formulating my investment plan: The Bogleheads’ Guide to Investing (don’t let the goofy title of the book fool you, it’s a very good guide to investing) and All About Asset Allocation.
• Making your own calculations: You may want to make your own calculations for retirement using assumptions that are different than what I’ve used. If so, here is the investment calculator I used in this article.

Invest Retirement Savings in Roth Accounts

I believe that for most people most of the time, Roth retirement accounts are best. Why? Well, let’s first look at the numbers. As with the above calculations, let’s assume you start saving at age 30, retire at 65, invest $15,000 annually for retirement, are in the 25% tax bracket and (this is important) will be in the 25% tax bracket during retirement. Under these circumstances, which is best, a $15,000 investment in a Roth 401(k) or a traditional 401(k)?

The Roth 401(k) beats the traditional 401(k). But this test is unfair. Investing in the Roth 401(k) costs us more because we don’t get an immediate tax break like we do with a traditional 401(k). So let’s assume that we invest the tax savings we enjoy with a traditional 401(k) into a taxable investment account. Now which is best?

The traditional 401(k) balance improves, but it still doesn’t catch the Roth 401(k) balance. Why? It doesn’t catch the Roth 401(k) balance because the after-tax money invested in taxable accounts doesn’t grow tax-free like the Roth 401(k) does. The difference in these two account balances represents the taxes you pay on the earnings from your taxable account. If you could invest the tax savings from the traditional 401(k) into a Roth IRA, the two accounts balances would be identical.

Now, what if your tax rate goes down during retirement? Here is a chart assuming a 25% tax rate during your working years and a 15% tax rate during retirement:

The balances get closer, but the Roth still edges out the traditional 401(k). Why? Again, it goes back to the fact that the tax savings from the traditional 401(k) are invested in a taxable account where taxes must be paid on all earnings. And if your tax rate goes up during retirement, the choice in favor of a Roth 401(k) becomes even more clear. If you’d like to play with these numbers and assumptions yourself, here is the Roth 401(k) versus Traditional 401(k) calculator that I use.

Now, let’s put aside the numbers for a moment and consider some additional factors that are important to this decision:

• Future tax rates are unknown: The fact is we don’t know what the tax rates will be a year from now, let alone 30 years from now. Many argue that they have only one way to go–up. Maybe, although the government can increase taxes without increasing the income tax rate. For my retirement investing decisions, I make no assumptions about future tax rates. How then, you may ask, do I make a decision between Roth and traditional retirement accounts?
• You can pick both: I invest in both Roth and traditional retirement accounts. Like so much in life, this is not an all or nothing choice. Since I don’t know where tax rates will go, I invest in both. My employer matches 401(k) contributions, and these matches must go into a traditional 401(k). Thus, I’ve started increasing the portion of my contribution that goes to a Roth 401(k). My goal is to direct 100% of my contributions to my designated Roth 401(k), while the matching contributions go to a traditional 401(k).
• Roth accounts bring certainty to retirement planning: One of the things I like about Roth accounts is that you know exactly what you have saved for retirement. With traditional retirement accounts, you have to make a guesstimate about taxes to know how much money you have to fund your retirement.
• Conversion to Roth IRAs: Roth 401(k) retirement accounts can be converted to Roth IRA accounts without any tax liability. I like this feature because Roth IRAs offer a distinct advantage over deductible IRAs and 401(k)s–no required minimum distribution during retirement. You can hold onto your Roth IRA for as long as want, and it is a great way to pass on wealth to your children or grandchildren if that’s one of your goals. If you’d like to read more about this feature of retirement accounts, here are two books I own that are very good on the subject of taking your money out of retirement accounts: The Retirement Savings Time Bomb . . . and How to Defuse It: A Five-Step Action Plan for Protecting Your IRAs, 401(k)s, and Other RetirementPlans from Near Annihilation by the Taxman and IRAs, 401(k)s & Other Retirement Plans: Taking Your Money Out.

The M-Network Dave Ramsey Baby-Step Series

Here are all of the articles thus far from the M-Network series:

• Overview at Cash Money Life
• Step 0 - No More Debt at Debt Free Revolution and Single Guy Money
• Step 1 - $1000.00 Emergency Fund (@Gather Little By Little)
• Step 2 - Pay off all debt using the Debt Snowball (@Paid Twice)
• Step 3 - 3 to 6 months of expenses in savings right here! (@ Being Frugal)
• Step 4 - Invest 15% of household income into Roth IRAs and pre-tax retirement (@ The Dough Roller)
• Step 5 - College funding for children (@ My Two Dollars)
• Step 6 - Pay off your mortgage (@Moolanomy)
• Step 7 - Build wealth and give! (@ Plonkee) Money
• Series Wrap Up (@ Being Frugal) and (@ Paid Twice)

Some time ago I wrote an article about Tim Ferriss’ book, The 4-Hour work Week: Escape 9-5, Live Anywhere, and Join the New Rich. My article questions just how realistic a 4-Hour work week is for must of us, and argued that achieving a 24-hour work week was more realistic.

The other day while cleaning out my workshop, I uncovered Tim’s book and decided to read it again. Oddly enough, I found it more enjoyable the second time through. But I still question just how realistic a 4-hour work week is for most of us, which in turn makes me wonder why the book is so popular. I have a theory about that and a series of questions for you. But first, let me cover the two aspects of the book I really enjoyed.

The 4-Hour Work Week forces us to question assumptions

We all make significant assumptions about our lives, even if we don’t realize it. We assume we have to work from 9 to 5 five days a week, if not more. We assume that debt is just a way of life that most everybody must endure. We assume we have to work hard until we’re 65 or older, only then to retire to a life of barely enough. Tim’s book questions those and other assumptions in a way that I find compelling. For example, here is a lengthy quote about retirement, which Tim describes as the “worst-case-scenario” insurance:

Retirement as a goal or final redemption is flawed for at least three solid reasons:

• It is predicated on the assumption that you dislike what you are doing during the most physically capable years of your life. this is a nonstarter–nothing can justify that sacrifice.
• Most people will never be able to retire and maintain even a hotdogs-for-dinner standard of living. Even one million is chump change in a world where traditional retirement could span 30 years and inflatinio lowers your purchasing power 2-4% per year. The math doesn’t work. The golden years become lower-middle-class life revisited. That’s a bittersweet ending.
• If the math does work, it means that you are one ambitious, hardworking machine. If that’s the case, guess what? One week into retirement, you’ll be so damn bored that you’ll want to stick bicycle spokes in your eyes. You’ll probably opt to look for o new job or start another company. Kinda defeats the purpose of waiting, doesn’t it?

We need to regularly challenge the assumptions that often unkowningly direct the course of our lives. The 4-Hour Work Week does a good job of helping us do just that.

Using virtual assistants

Tim’s book introduced me to the concept of virtual assistances, or VAs as they are called. A VA is an individual you hire online to help you with just about anything that doesn’t require their physical presense. VA’s can create logos, design websites, conduct research, write articles, make reservations and more.

I’ve never used a VA. After reading his book a second time, however, I’ve reached out to several VAs to inquire about price and to see just how I might use them to make my life easier and more productive. I’ll let you know how that goes, but if you have used a VA before, please leave a comment describing your experience. If you are interesting in hiring a VA, here are some online resources to check out:

• Assist U
• Your Virual Resource
• IVAA
• Canadian VA
• Online Business Manager
• Elance

Why is the 4-hour work week so popular?

I suspect that the vast majority of people who buy The 4-hour Work Week don’t actually follow the advice Tim gives them. If that’s true (and feel free to disagree), than why is it a New York Times bestseller being translated into more than two dozen languages? Learning about VAs was great, but I doubt that accounts for the success of the book. I believe people buy the book because they enjoy the dream. It’s the same reason people buy lottery tickets. The best part about buying a lottery ticket is not winning. Almost nobody wins the lottery, and certainly nobody expects to win when the buy a ticket. The best part about playing the lottery are the few days between buying the ticket and the drawing, when you can dream about winning.

So here are my questions to all of you:

1. If you’ve read the book, have you tried to implement Tim’s strategy to achieve a 4-Hour work week?

2. If you have, what were your results?

3. If you haven’t, why not?

4. And if you haven’t read the book, but would love to work just four hours a week, why haven’t you gone out and bought or borrowed the book?

For me, it’s question #3 that I must answer. I’m going to answer that question in another post, but first I’d like to hear from all of you.

According to a report just released by the National Academy of Social Insurance, the average monthly benefit for retirees is $1,045 in 2007. A 65-year old who wanted to buy a guaranteed income of that size – with payments that go up with the cost of living and continue for a widowed spouse — would need to pay an insurance company about $225,000. The report also found that with social security, 10 out of every 100 retirees are living in poverty. Take social security away, and the number would jump to 50 out of 100. DR NOTE: If you are not saving for retirement, start today!

The report is worth reading if you’d like a primer on social security. Social Security: An Essential Asset and Insurance Protection for All (48 page pdf document) includes a section describing social security benefits and how they are calculated. For example, the percentage of income replaced is higher for lower income families (as you’d expect). Here’s a chart from the report depicting this aspect of social security:

The report also notes that while most associate retirement with social security, the program covers a lot more. A full 31% of social security benefits are paid out as disability payments or life insurance.

The future financial health of social security is sobering. The report notes that by 2041, “dedicated Social Security taxes coming into the program will cover only 75 percent of the benefits promised under current law.” Social Security benefits now represent 4.3 percent of the nation’s gross domestic product, but this percentage is expected to rise to 6.2 percent by 2030. This rise is the result of the aging of the baby boomers combined with the simple fact that people are living longer.

Source: National Academy of Social Insurance

” Those who fail to plan, plan to fail. If Voyant’s newly released online financial planning tool has anything to say about it, failing to plan will be a thing of the past. Voyant showcased its free financial planning tool at DEMO 08 being held this week in Palm Desert, CA. I’ve spent some time using the financial planning tool, and it has real potential. Here’s how Voyant describes it’s tool–

Read the rest

Recently a reader e-mailed me with the following question:

I definitely do want to open a Roth IRA as soon as possible because I hear it’s typically better than the Traditional IRA. However, I’m not certain whether one should be putting money way in one’s 401K or Roth. As you can tell, I’m not that financially knowledgeable. I do have some credit card debt that shouldn’t take too long to pay off and of course I have some student loans. I’m guessing you’re recommending me to pay off my credit card debt first before opening a Roth IRA. My student loans on the other hand will take a while to pay off.

I receive questions like this a lot, and so today we’ll walk through an approach you can use to answer these questions for yourself.

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