Dave Ramsey’s Baby Steps to financial peace have become a popular way to get control of finances. In case you’re not familiar with the Dave Ramsey approach to money, here are the 7 Baby Steps:

  • 1) $1,000 to start an Emergency Fund
  • 2) Pay off all debt using the Debt Snowball
  • 3) 3 to 6 months of expenses in savings
  • 4) Invest 15% of household income into Roth IRAs and pre-tax retirement
  • 5) College funding for children
  • 6) Pay off home early
  • 7) Build wealth and give!

While there are those who quibble with some aspects of these steps, by and large it’s a sound approach to money management. If my children when they leave home decide to follow the Dave Ramsey way of handling money, I’ll take great comfort that they are headed in the right direction.

But what about those of us who aren’t just starting out or recovering from a financial meltdown. For many of us, when we look at Dave’s Baby Steps, we realize that we have been taking on many of these steps at the same time! For example, we have a lot more than $1,000 in our emergency fund, yet we also have non-mortgage debt, we save for our children’s education (my son starts college in three years), we save for retirement, and we give money to charity.

And all of this raises the question we are going to address: Should we ‘Dave Ramsey our finances‘, and if we did, would we be better off?

To answer this question, let’s walk through the Baby Steps (particularly ##1-3) using the following assumptions:

  • Non-retirement savings: $50,000 in a mix of mutual funds and cash accounts.
  • Non-mortgage debt: $200,000 (mainly from a home renovation) on a home equity line of credit and low-interest credit cards.
  • Mortgage: $400,000 on a 30-year fixed rate of 5.5%.
  • College Savings: $10,000 in a 529 Plan with kids a few years away from college.
  • Retirement Savings: $250,000 in 401(k) and IRA accounts.
  • Retirement Contributions: Currently contributing 7% to company 401(k), and company matches up to 7%.

Everybody’s specific financial conditions are different, of course, but the above assumptions will allow us to work through some of the significant issues and opportunities Dave Ramsey’s approach can present.

Dave Ramsey Baby Step #1: $1,000 Emergency Fund

Unlike those trying to save $1,000, many who chose to follow Dave Ramsey’s Baby Steps would be in the position of draining their emergency fund down to $1,000 and using the funds to pay down debt. From just a numbers perspective, using an emergency fund to pay off non-mortgage debt is usually the right choice.

Emergency funds should be kept somewhere risk-free, like in an online, high yield savings account. These accounts almost always pay less than the interest on the debt. In addition, the interest a savings account does pay is taxable, while interest payments on credit cards and personal lines of credit generally are not tax-deductible.

Of course, many may have debt on 0% balance transfer credit cards or on home equity lines of credit that are tax-deductible. But for the most part, interest on the debt will be more than the interest earned on a savings account.

The big issue here for many is psychological. Having taken some comfort in an emergency fund that could pay expenses for some number of months, it will be very difficult to reduce the emergency fund to just $1,000. If that describes you, how would you answer the following question: If you had no debt and $1,000 in savings, would you borrow money to add to your emergency fund? If the answer is no, then you should ask why you are holding onto more than $1,000 while you carry non-mortgage debt.

There may be some tax considerations that come into play. If some or all of your non-retirement cash is in mutual funds or stocks, selling the investments to pay off debt could trigger tax liabilities. But putting this issue aside and returning to our example: let’s assume that we follow Dave Ramsey’s Baby Step #1 and transfer $49,000 from our non-retirement accounts to pay down our $200,000 in debt. That leaves $151,000 in debt and $1,000 in savings.

Dave Ramsey Baby Step #2: Pay Off All Non-Mortgage Debt

Baby Step #2 is to pay off all non-mortgage debt. Having reduced our emergency fund down to $1,000 as part of Baby Step #1, we now have two big questions to answer: (1) Do we use some or all of our 529 Fund to pay down debt?; and (2) Do we use some or all of our retirement investments to pay down debt?

Recall that retirement savings are Baby Step #4, and college saving is Baby Step #5. As a result, if we followed Dave Ramsey’s approach to the letter, it would seem that we would liquidate college savings first (since it’s further down, at step #5) and retirement savings second, until we had paid offer all of our non-mortgage debt. Let’s take a look at each option.

College Savings Fund: There are tax consequences for using a 529 Fund for something other than our children’s education. Generally, this is a 10% penalty, in addition to taxes, on your earnings. If you received any state income tax breaks on your contributions, those must also be paid back. Given the market today, however, you may not have substantial earnings, so the cost of closing out a 529 Fund may not be very significant. You can check out IRS Publication 970 for more information on 529 Plans.

In addition to the numbers, there are likely to be strong feelings among family members when it comes to a 529 Plan. Education is highly valued, as it should be, and the thought of draining a child’s education fund may not go over very well with your spouse, parents, or in-laws, not to mention your children. This is of particular concern if you are likely to rack up more credit card debt after paying it down with 529 Plan money.

In our example, however, let’s assume we close out the 529 Plan. After, say, $500 in penalties and taxes (assuming we have little by way of earnings given the current market), we are left with $9,500 to pay down our debt. That leaves us with $141,500 in non-mortgage debt.

Retirement Savings: This is the toughest decision. Unless you have Roth accounts, withdrawals from retirement accounts generally result in a 10% penalty in addition to tax liability. In our example (assuming the retirement savings are not in a Roth), we’d pay a $20,000 penalty if we withdrew the entire amount. Assuming a state and federal combined tax rate of 25%, we’d pay another $50,000 in taxes (which are calculated on the full $200,000, not the $180,000 leftover after the 10% penalty).

That would leave us with $130,000 to apply to our debt. So having liquidated all of our retirement and non-retirement accounts, we have our non-mortgage debt down to $11,500. If we did this, would we be better off? To answer that question, let’s compare our balance sheet before and after:

Before After
Non-Retirement Cash and Investments $50,000 $1,000
Retirement Savings $150,000* $0
529 Plan $10,000 $0
Total Assets $210,000 $1,000
Non-Mortgage Debt $200,000 $11,500
Net Worth (Deficit) $10,000 ($10,500)

*Net of taxes at an assumed 25% combined state and federal tax rate

Wait… why the difference in net worth? The difference comes from the $20,000 in penalties paid for withdrawing retirement funds and the $500 in penalties and taxes

for closing out the 529 plan. So, what if we stopped short of taking money out of retirement, but cashed in our emergency fund and 529 plan? Here are the numbers.

Before After
Non-Retirement Cash and Investments $50,000 $1,000
Retirement Savings $150,000* $150,000*
529 Plan $10,000 $0
Total Assets $210,000 $151,000
Non-Mortgage Debt $200,000 $141,500
Net Worth (Deficit) $10,000 $141,500

*Net of taxes at an assumed 25% combined state and federal tax rate

Here, the difference in net worth is the $500 in penalties and taxes for withdrawing money from the 529 Fund. Other than this difference, there are no changes in the bottom line on our balance sheet… at least not right away.

Where the difference comes into play is with the interest savings, if any, that we receive by paying off our debt — especially interest that costs us more than the interest we were earning on our savings and investments. As a result, the higher the interest rate on debt, the more benefits one receives by using savings to pay down debts.

Dave Ramsey’s Baby Steps ##3-7

So, where do we go from here? Well, if cashing in savings and investments is enough to pay off all non-mortgage debt, Dave Ramsey would have us rebuild our emergency fund up to 3 to 6 months worth of expenses. But what if you still have non-mortgage debt even after using all reasonably available sources of cash to pay it down? Certainly we wouldn’t move on to Step #3 until the debt was paid off, but other questions still remain.

For example, do you stop contributing to retirement (Baby Step #4) until the debt is repaid? And do you stop saving for your children’s education (Baby Step # 5) until the debt is paid? While there’s no one-size-fits-all answer to these questions, here’s one approach to consider:

  • Retirement Savings: Continue to contribute to retirement savings, at least to get 100% of any company match. In the long run, this approach should increase net worth more than leaving the company match on the table. This is the approach we are taking.
  • 529 Fund: Stop funding your child’s education until all non-mortgage debts are paid, you have a reasonable emergency fund, and you are saving for retirement. In the worst-case scenario, our children can pay for their own college and/or we can help them out of our then-current income. It just doesn’t make sense to save for future college expenses while paying interest on current debt.

Related: How and Why to Track Your Net Worth

Conclusion and Warning

From all of this, here are the key points for those trying to apply the Dave Ramsey Baby Steps:

  • Cash accounts earning low-interest rates should generally be used to pay higher interest debt.
  • Tax consequences should be considered before liquidating non-retirement investment accounts to pay off debt.
  • Using 529 funds to pay off debt should be considered, factoring in any penalties and taxes you’d have to pay (and just how angry your in-laws would be).
  • Retirement savings, because of the 10% penalty on withdrawals, will often not be a good source of funds to pay off debt.
  • Continuing to fund a 529 account while paying interest on the non-mortgage debt could cost more in the long run.
  • Contributions to retirement accounts, at least to take advantage of an employer’s match, is a sound choice.

In the final analysis, we are following a modified version of the Dave Ramsey approach to money management. We are using most of our cash and any non-retirement investments with few gains to trigger a tax liability to tackle our non-mortgage debt. We’ll continue to fund our 401(k) up to the company match, but direct all other funds toward our debt. Once the debt is paid, we’ll beef up our cash accounts and education savings.

Finally, there are two big warnings to heed. First, every situation is different. The tax consequences of the decisions you make vary from person to person, tolerance for risk varies, and the need for liquidity can vary. The point is that the above perspective, while generally the approach we are taking, may not be right for you. If you are looking for advice before you make any financial decisions, seek the advice of a professional.

Second, it is important to understand your own tendencies. If you believe that you’ll likely accrue more debt once the credit cards are paid off, it may not make sense to cash in your savings account to pay them down. The one “advantage” to a maxed-out credit card is that you can’t borrow any more on it.

All of which is to say, “To thine own self be true.”


  • Rob Berger

    Rob Berger is the founder of Dough Roller and the Dough Roller Money Podcast. A former securities law attorney and Forbes deputy editor, Rob is the author of the book Retire Before Mom and Dad. He educates independent investors on his YouTube channel and at RobBerger.com.