This one is easy. By this point, you have no debt payments except for maybe your house. Taking 15% off the top should be easy enough to accomplish.

The first big question is where to stash it all.

Well, if your employer offers a Roth 401(k), that’d be your best bet to get started. If you have adequate control over the investments in the account, you should look at maxxing out your contributions to the Roth 401(k) account. If you’re choices are limited, then contributing to the Roth 401(k) up to any employer match is your best bet.

If your employer does not offer the Roth version of the 401(k), you will still want to contribute into a traditional 401(k) up to the employer match. Or, if your employer offers a 403(b) or TSP, you’ll want to contribute into those programs.

After maxxing out your 401(k) or other pre-tax retirement account, you’ll want to try putting the rest into a Roth IRA. With Roth IRA accounts, you may be, depending on income limits, allowed to contribute up to $5,000 per person (as of 2008). Income limits for 2008 are up to $101,000 for single filers and $159,000 for married filers.

If, after contributing to your employer’s retirement account and Roth IRA, you are still not up to 15%, you will want to go back to your employer’s retirement account and contribute enough to get you to 15%.

For more information: There’s a great article on Wikipedia that compares the different IRA and 401(k) types: 401(k) IRA matrix.

Now that you have your accounts setup and 15% of your income going in, you need to figure out how to invest it.

Dave’s investment philosophy is quite simple:

25% into each of these four types of [mutual] funds:

• Growth
• Growth & Income
• Aggressive Growth
• International

And, to expand on what Dave says, I’m going to point you to the folks over at Merriman Berkman Next and their Merriman Model ETF Portfolios. Dave’s biggest requirement for financial advisers is that they have “the heart of a teacher.” Well, Paul Merriman and the guys fit that reqirement. They have a free weekly podcast called Sound Investing that offers great advice and learning. In addition, Merriman Berkman Next offers free educational workshops.

We’ve made it through paying off all of our debt (except for our home), now it’s time to move to Baby Step Three and fully fund our emergency fund.

There’s really not much to this step except to pile up cash into our money market account (MMA) where we kept our baby emergency fund from Baby Step One. Before moving to Baby Step Four, we need to get enough cash to cover three to six months worth of expenses not income.

If you’re on your own or just you and a spouse, you’d probably just fine to stop at three months worth. If you have a house full of kids, well then six months would make more sense.

Right now until December 18th, Merriman Berkman Next is offering Paul Merriman’s Live It Up Without Outliving Your Money: Getting the Most from Your Investments in Retirement book and DVD for just $25.00!!! That price includes shipping, handling, and sales tax. Awesome!

From the website:

The book and DVD provide lots of timeless advice on money and retirement, including:

• Which mutual funds to own
• How to build a portfolio for good markets and bad markets
• How to reduce fees
• What you should know about your advisor!

And now we are to the meat of the plan. Baby Step Two is the Debt Snowball.

When paying off debt, there are many different ways to prioritize your debts: smallest to largest balance, smallest to largest minimum payment, largest to smallest interest rate, and so on.

The Debt Snowball is Dave’s preferred method for debt repayment. The debt snowball orders the debts from smallest balance to largest and pays them off in that order. Mathematically that doesn’t make a whole lot of sense. You know that. I know that. Dave knows that. The thing is, however, Dave has been doing this for decades. I think that we can trust his judgement on this. But, if you really want to know why he chose the mathematically inferior snowball method, it has to do with psychology more than math. By placing your smallest debts at the top of the list and paying them off first, you build psychological momentum which carries through the rest of your debt.

The Debt Avalanche is where you place your debts in order by interest rate with the higher interest debts at the top of your list. If you’re a nerd and just cannot follow the debt snowball method due to the math, the debt avalanche is your plan.

A variation of the debt snowball, called the Dead On Last Payment (DOLP) Snowball, uses a payment to balance ratio to order the debts. The P/B Ratio is the Balance Due divided by the Minimum Payment. You then order your debts by ratio from lowest to highest. In essence, this balances the snowball and avalanche methods as debts with higher interest rates will tend to have higher minimum payments and, therefore, a lower P/B Ratio.

For example, let’s look at a $5,000 loan at 6% and 12%.

6.00% – Minimum payment = $96.66. P/B Ratio = $5,000 / $96.66 = 51.7.
12.00%  – Minimum payment = $111.22. P/B Ratio = $5,000 / $111.22 = 45.0.

You can see that using the DOLP Snowball method will tend to favor paying off higher rate, smaller balance loans.

So, if you are truly unable to follow the plan laid out by Dave and the Debt Snowball, the DOLP Snowball should provide an acceptable alternative.

The only way to get out of debt is to stop going into debt. You can’t fill a hole while you’re digging out the bottom. What does this have to do with an emergency fund?

Well, let’s pretend that we’ve done our budget and now we jump straight to throwing all available cash at paying off debt. We have no emergency fund at all. Now the transmission on the car goes out and that is the only way to get the kids to school, dad to work, and groceries home from the store. You can’t go without the car. (Let’s not even talk about the state of public transportation in the U.S.) You have to get the car fixed, but $600 is too much cash to come up with on a moment’s notice. So out comes the “For Emergencies Only” credit card. The hole just got dug a bit deeper. Now we’ve fixed the car and the hot water heater decides to empty its contents into the laundry room. I don’t even know how much a new hot water heater costs nor do I know how much it will cost to repair the damage caused by the associated mini-flood. But where does that cash come from?

So what do we do? Well, if you had setup an emergency fund before starting your debt reduction plan, you could have paid cash for those emergencies rather than go further into debt.

Dave’s Baby Step One calls for $1,000 in the bank in what he calls a “Baby Emergency Fund.” A $1,000 is not enough for a real emergency fund, but while we are working to get out of debt, it will provide the short term buffer we need.

Where should this money get put? Well, it needs to be easy to get to in case of emergency, but not so easy to get to that a trip to the supermarket gets classified as an emergency when the budget for food is running low.

A great place to put this is a money market account that has check writing privileges. Bankrate.com is a great site to use to search for money market accounts based upon features, rates, locations, etc. Personally, we use GMAC Bank for our emergency fund. As of November 26, 2008, they are paying 3.2% APR on their MMAs. You can access your account online and transfer funds from your checking account into your MMA. You get checks and a check card for account access.

Once your $1,000 baby emergency fund is in place, it’s time to move onto Baby Step Two…