It may sound crazy to start talking to your teenagers about retirement and IRA's, but it's not. My son is in his first year of high school and trust me, the last thing he wants to hear about is retirement!! His greatest worry right now is getting his parents to let him get a drivers permit. But, if you can help your children get started saving money now, the benefits are truly unsurpassed and they will thank you later.
Here is a great article from The Independent Adviser for Vanguard Investors that discusses various options for getting your teenager started -- and how the compounding effects of small contributions now will set them up for their future. Helping your teenager get started by offering to match their earnings into an IRA or even matching a small portion that they set aside will really make a difference.
Retirement
Open Your Teen an IRA
Every year, when I write about opening an IRA for your teen or grand-teen, I hear from FFSA members, friends, and even family who say, in a nutshell, "Great idea." And it is. Helping a young person get on board the retirement train may not get you lots of appreciation today, but trust me, the beneficiary of your forward thinking will thank you for years to come as they move into adulthood.
Whether you call them Millennials, Gen Ys, or Echo Boomers, the Internet generation is a massive group of teens and 20-somethings who could use a kick in the pants when it comes to planning for retirement.
I know it sounds a bit crazy to talk to teenagers about retirement and IRAs. I can hear the howls of laughter. "Retirement?" you ask. "Who are you kidding? The kid couldn't care less about retirement. He's more interested in Instagram and Snapchat."
Maybe. Maybe not. Last year I helped a number of 25-year-old friends of my daughter with some fundamental financial and investment planning. They needed it; they knew they needed it; and they were very appreciative of the help. In fact, one of them wrote a blog post about it, then went on to put her money to work for her future.
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 them start to build a Roth 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 and April, you can tote up what Mr. or Ms. Millennial earned in 2014 and fund that IRA account before the April 15 deadline.
I know that it would be nice if junior spenders could take on this chore themselves, but how many teens do you know who read investment newsletters? 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 why parents (or grandparents) were invented.
When I first opened an IRA for my then-teenaged son, both he and my wife looked at me like I'd just announced my intention to run for President. My daughter just smiled and kept reading her book.
The joke is on them, of course. Thanks to me matching my son's summer earnings and putting the money away in a Roth IRA, the now almost-30-year-old has already built up a tidy sum that will continue to grow for many years to come. It won't pay for a nursing home just yet, but then again, he's got a few years before that becomes an issue. And he's learned the value of early and long-term investing and compounding. With a good job, he's already saving outside his IRA and is funding a 401(k) at work. My daughter's IRA, smaller because she's younger, is also growing (I matched her earnings, too). Unfortunately, in the startup where she currently works, 401(k)s are still an unknown.
Okay. That's my kids. What about yours? Let's go back and review my thinking on the teenage Roth IRA, so you won't put this off. It's important and especially timely given that the April 15 deadline for contributions seems to sneak up quickly on those who've procrastinated about making their deposits.
The Roth IRA is an excellent retirement savings vehicle for younger people. Since their introduction in 1998, Roth IRAs have been garnering respect (and dollars) from knowledgeable investors for the advantages they have over traditional IRAs.
While a traditional IRA allows you to deduct your contributions pre-tax, it also locks your money in until you are 59½ years old (unless you feel like paying a 10% fee on withdrawals, plus income taxes), and forces you to take distributions upon reaching the age of 70½, paying income taxes at your future—and possibly higher—tax rate.
In contrast, when contributing to a Roth IRA, you invest with after-tax dollars now and can withdraw funds tax-free after the age of 59½ or if you meet other IRS qualifications (for instance, if the 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 requirement on distributions—if you don't feel like taking money out or don't need it, you can leave it in there to continue growing.
Why do I continue to preach the benefits of IRAs as great starter investments 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 this economy, many first-time jobs don't come with 401(k) retirement plans attached, so there's no other available vehicle for forced retirement saving. Plus, for most, an IRA gives you more flexibility over where and how to invest. 401(k)s often have few, and sub-par, investment choices.
The power of compounding is what really makes any kind of tax-deferred investment a superb bargain. The definition of compounding is "the act of generating earnings from previous earnings." Confused? Here's an example: Let's say you make a $100 investment in a fund that rises 20% in a year. After that year, you'd have $120. Instead of selling your shares, you let them ride, and the fund gains another 20% the next year, bringing your investment value up to $144. That's an additional $4 in gains over the first year (or 4% on the original $100 investment) generated because you gained 20% not only on your original investment, but also 20% on all the gains 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. If you start actively investing a set amount each year, adding to the amount generated by what the investment earns on its own, you create even larger potential earnings.
In the table below, I set up several different savings scenarios for illustration. All of them assume a 6% annual return, with the difference in 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 for 2014) from the age of 15 to 70.
Finally, the sixth scenario attempts to show a conservative, natural progression a young person might follow as they age and gain employment: Starting with their first summer job at age 15, they invest $1,000 a year until they graduate from college and get settled into a career, bumping their contribution up to $2,000 a year at 23. By age 30, they will (hopefully) be well-established and able to again bump their contribution up to $4,000, and at 40 bump it up again to $5,500, an amount they continue to contribute up until retirement.
You can see that the greater the contribution and the greater the time that's passed, the larger and faster the account grows. That is the power of compounding—by constantly adding to your investment, you increase the potential return, going from what seems like a paltry $1,000 initial investment at age 15 to $225,000 by age 60, simply by adding $1,000 a year to the account, achieving a 6% annual return and paying no taxes on your income and gains. With larger initial (and subsequent) investments, you get even more bang for your bucks.
| Age | $1,000 A Year | $2,000 A Year | $3,000 A Year | $4,000 A Year | $5,000 A Year | Gradual Increase |
|---|---|---|---|---|---|---|
| 15 | $1,000 | $2,000 | $3,000 | $4,000 | $5,500 | $1,000 |
| 30 | $24,673 | $49,345 | $74,018 | $98,690 | $135,699 | $37,284 |
| 60 | $225,508 | $451,016 | $676,524 | $902,032 | $1,240,295 | $612,935 |
| 70 | $417,822 | $835,645 | $1,253,467 | $1,671,289 | $2,298,023 | $1,174,517 |
| Assumes a 6% annual rate of return. | ||||||
But I also put together another scenario that may be more realistic, particularly when we're talking about real markets and real teenagers. First off, few teenagers are going to be able to earn $5,500 in a summer, though they might be able to hit that number or higher if they work during the school year.
Also, as you know, markets don't compound in a straight line. They go up and down. So, in the charts below, I've assumed that our teen (or guardian angel) is not only socking away more modest sums, but does so from the age of 12 to the age of 25, when, presumably, Junior will be out working, saving and investing on his or her own.
In the three scenarios, I've assumed the actual returns from Total Stock Market, Total Bond Market and Wellington from 2000 through 2013.
Despite two stock bear markets during this period, Wellington, which keeps about 60% of assets in stocks and the remainder in bonds, matched or slightly beat the returns from Total Bond Market as well as Total Stock Market.
These charts might be just the thing to show the teen or young adult you're interested in leading down the road to retirement. I hope I've both made the benefits of funding an IRA clear, and simplified it enough that a young investor can understand it. But the question remains: How can we get a teenager to save for retirement?
You probably can't. So, my advice is to help them. That's what I did with both of my kids.
Let's assume you can afford to match their summer earnings. Do it. Let them have their hard-earned money, but open a Roth IRA in your child or grandchild's name and add the money yourself. Remember, the child may earn $1,000, but with taxes taken out, they will not bring it all home. That doesn't keep you from putting a full $1,000 into a Roth for them.
Maybe you can't afford to add the full amount. Consider making a deal with your teen to match a portion of their earnings that they add to the Roth as well. If the teen contributes $250, maybe you'll contribute $500. Grandparents, obviously, can get into this act.
Finally, there's the issue of the many $3,000 minimums at Vanguard. First off, you could start the youngster in a STAR account for just $1,000. While I'm not a huge fan of STAR because of the amalgam of funds it cobbles together, its one saving grace is that low, low minimum. My preference, however, would be to go directly to one of the PRIMECAP Odyssey funds (POAGX, my favorite for kids, is now closed, so go for POGRX), where the IRA minimums are just $1,000.
Or, if you have a personal representative at Vanguard, see if they'll waive the minimum onSelected Value or Dividend Growth for your child or grandchild. Obviously you won't be making regular contributions to the IRA, since its deposits are contingent on the child's income stream, but if Vanguard's smart, they'll see this as a way to grab a potential long-term client at an early age.
Remember, the longer you or your children wait, the smaller your potential compounded earnings. Of course, with income comes taxes, and your children will need to begin filing their own tax returns. And, as I mentioned earlier, contributions to a Roth IRA are not made pre-tax, as they would be on a traditional IRA. Also, be aware that if you do help your child by contributing on their behalf, the total amount put into the IRA cannot exceed their total earnings in any given tax year. (This will be more of a concern for the youngest investors.)
In any case, helping to put your teenage child or grandchild on the road to a more comfortable retirement may truly be one of the best gifts you can make, and it will be one that keeps on giving year after year.
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