Spend Money on Your Kids the Right Way

05/12/2011 9:00 am EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Stash your kids’ summer earnings in a Roth IRA and put the power of compounding to work for them, writes Daniel Wiener of the Independent Adviser for Vanguard Investors.

Here's a big story on retirement saving that I've been promoting for years. It's one that doesn't get a lot of press, yet every time I mention it to a friend of mine, or write about it, I hear how great this idea really is.

The story: Helping your teenage child, grandchild, or even a friend begin the long road to retirement on the proper foot.

I can hear the howls of laughter right now. "Retirement?" you ask. "Who are you kidding? The kid's a kid and couldn't care less about retirement."

That's right. And that's why now is a great time to begin preparing, while time is on the kid's side, by starting to build a Roth IRA with earnings from the upcoming summer and part-time jobs. Then, next March and April, you can tote up what Junior earned in 2011 and fund that IRA account for him or her before the April 15 deadline.

It would be nice if junior spenders could take this chore on 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 they invented parents (or grandparents).

I remember when I first opened an IRA for my then-teenaged son. Both he and my wife looked at me like I'd just announced we were moving to Siberia.

The joke is on them, of course. By matching my son's summer earnings and putting the money away in a Roth IRA, our almost-27-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. My daughter's IRA, smaller of course, is growing as well.

OK. That's my kids. What about yours? Let's review the teenage Roth IRA, so you won't put this off. It's important, and especially timely.

NEXT: Rock and Roth


Rock and Roth
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 59 1/2 years old (unless you feel like paying a 10% fee on withdrawals, plus federal taxes), and forces you to take distributions upon reaching the age of 70 1/2, paying federal 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 59 1/2 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 for Roth IRAs—if you don't feel like taking money out or don't need it, you can leave it in there to continue growing.

Why am I so adamant that these are 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 means of forced saving for retirement. Plus, for most, an IRA gives you more flexibility in where and how to invest. 401(k)s often have few, and subpar, investment choices.

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 $1,000 increments from $1,000 to $5,000 (the maximum currently allowed under IRS rules for investors age 49 and younger for 2011) from the age of 15 to 70.

Yes, I realize that with the markets having earned little over the past ten years, the notion of a compounded 6% return looks rather quaint—and ridiculously large. But remember, the long-run average for stocks is closer to 10%—and our kids have, as I said, almost 50 years to go.

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 by 23.

By age 30, they will (hopefully) be well-established and able to again bump their contribution up to $4,000, and at 40 a bump again to $5,000, an amount they continue to contribute up until retirement.

Click to Enlarge

You can see that the greater the contribution, and as more time passes, 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 and achieving a 6% annual return. With larger initial (and subsequent) investments, you get even more bang for your buck.

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?

My advice: Help them. That's what I did with both of my kids.

NEXT: The Gift That Keeps on Giving


The Gift That Keeps on Giving
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.

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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