The Tax Season filing deadline causes many clients to set up or contribute to their IRA. Contributions must be made before the tax filing deadline. At this point, you are about to ask me what’s that got to do with a teenage millionaire. It has lots to do. The opportunity that I’m talking about is contributing to your teenage son or daughter’s IRA or your teenage grandchild’s IRA. How does this work? Frequently teenage kids work at part-time summer jobs (you can even employee your child or grandchild), and this “earned income’ qualifies them to make a contribution to an IRA account. A Roth IRA is particularly smart because the teenager typically does not have sufficient income to pay taxes. When you make the contribution to your teenager’s Roth IRA, they get an early start on accumulating a future tax-free (the Roth account must be established for five years before tax-free withdrawals) pot of money that can be used for retirement or other needs of a now adult teenager.
I know it sounds a bit crazy to talk to teenagers about retirement and IRAs. I can hear the howls of derision. “Retirement? Who’s kidding who? I need a job.” Most kids are, not surprisingly, more interested in Instagram and Snapchat than they are in retirement. In fact, given a choice, they’d probably prefer cleaning out the garage to thinking about how they’ll pay for living expenses 60 years down the road.
But that shouldn’t stop you from trying to pique their interest in the basics of personal finance, and yes even personal financial responsibility. Let me share with you a couple stories. First, there’s case of an even younger child (just before being a teenager); the clients’ son was selected by a modeling company and was given a contract that went on for four years and with our guidance, the parents opened an IRA for their son. This gave him a four-year jump start on building his savings in an IRA. Their son later started doing summer jobs and continued contributing to his IRA. Another client with teenage grandchildren organized a family meeting and then started matching the amount of the grandchildren’s earnings from part-time or summer jobs. What a fantastic idea.
It’s too bad more people don’t help the young get started early on their investment careers because the perfect time to learn about saving and investing is when your portfolio is small enough that your mistakes won’t kill you. Also, it’s a time when a new investor can begin to develop lifelong habits that will stand them in good stead as they pass through their 30s, 40s and beyond. Time is on a kid’s side, and by helping one start to build and IRA with earnings from summer and part-time jobs, you may be able to make a meaningful impression on him or her. Then next March or April, you can tote up what Mr. or Mrs. Parent (or, Grandparents) earned and fund the IRA account before the tax deadline.
I know this would be nice if Junior spenders could take on this chore themselves, but how many teens do you know that are interested in investments, saving for the future or much less retirement. And if they did, where would they get the money to stash in an IRA? Most spend what they make, and then some. That’s one reason I believe the world invented parents (and grandparents).
Okay. Now I’ve told you about a couple of client stories. What about yours? Let’s go back and review our thinking on the teenage Roth IRA, so you won’t put this off. It’s important. Now is the time to get ready before we reach next year’s tax filing deadline. Don’t procrastinate…tax deadlines seem to sneak up on you. Start now to prepare for next year.
The Roth IRA is an excellent retirement savings vehicle for younger people. Since their introduction, Roth IRAs have been garnering respect (and dollars) from knowledgeable investors for the advantages they have over traditional IRAs. With a Roth IRA, you invest after-tax dollars now and can withdraw funds tax-free after age 59 1/2 or if you meet other IRS qualifications (for instance if distributions will be used for a first-time home purchase—something today’s kid might appreciate tomorrow—or to help with a disability). Once you do hit retirement, there is no required distribution—if the owner doesn’t feel like taking money out or doesn’t need it, he or she can leave it in the Roth IRA to continue growing.
Why do we continue to preach the benefits of Roth IRAs as a great starter investment for teenagers or young adults? Simple: Taxes and the power of compounding. If your child is only working for the summer, or just starting their professional career, they will likely be in one of the lowest tax brackets, making it a fantastic deal to pay taxes on their retirement savings now as opposed to when they are older and in a higher bracket. And in today’s economy, many first time jobs don’t come with 401(k) retirement plans attached (part-time jobs rarely ever do), so there are no other forced retirement savings.
The power of compounding is what really makes any kind of tax-deferred investment smart. The definition of compounding is “the act of generating earnings from previous earnings.” Here’s an example. Let’s say you make a $1,000 investment in a fund that rises 20% in a year. After that year, you’d have $1,200. Instead of selling your shares, you let them ride, and the fund gains another 20% the next year, bringing your investment value up to $1,440. That’s an additional $40 in gains over the first year (or 4% on the initial $1,000 investment) generated because you gained 20% not only on your original investment but also 20% on all money you earned in the first year. While this may not seem like an impressive amount, with each passing year that earnings potential grows even higher so long as the investment prospers.
In the table below, we’ve set up several different savings scenarios for illustration. All of them assume a 6% annual return, with the difference in the scenarios being the amount contributed per year, increasing in increments from $1,000 to $5,500 (the maximum currently allowed under IRS rules for investors age 49 and younger).
Growth of Roth IRAs*
Age $1,000 /Yr $2,000/Yr $3,000 /Yr $4,000/Yr $5,500/Yr
15 $1,000 $2,000 $3,000 $4,000 $5,500
30 $24,673 $49,345 $74,018 $98,690 $135,699
60 $225,508 $451,016 $676,524 $902,032 $1,240,29
70 $417,822 $835,645 $1,253, 467 $1,671,289 $2,298,023
*Assumes 6% annual rate of return.
We hope that we have made it abundantly clear of the benefits of funding an IRA, simplified enough for a young investor to understand. But parents should note that if the youngster failed to invest his or her own part-time income, parents would be smart to contribute for the young person, at least up to the maximum and the amount of child’s earned income.
The information and stories explained and describe above provide parents and grandparents an “how to” opportunity to give their children and grandchildren a strong financial foundation for their future lives. It also can be an outstanding teaching experience to get teenagers an early understanding of how long-term investing really works.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk, including the risk of loss.
Blog No. 114 – A Teenager’s Path to a Millionaire Retirement
Sources: Internal Revenue Code, Douglas &