IRAs for teens? No, I haven’t lost my mind. I remember when I first mentioned opening an IRA for my then-teenaged son. Both he and my wife looked at me like I’d just announced we were moving to Pluto. But they aren’t looking askance any longer. By matching my son’s summer earnings and putting the money away in a Roth IRA, the 24-year-old has already built up a tidy sum that, despite last year’s drubbing, will continue to grow for many years to come. And, he’s learned the value of early and long-term investing and compounding.

Roth IRAs vs. Traditional IRAs

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 federal taxes), and forces you to take distributions upon reaching the age of 70½, 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 59½ or if you meet other IRS qualifications (for instance, if the distributions will be used for a first-time home purchase 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, you can leave it in there to continue growing. So why are these great starter investments for teenagers or young adults?

The Power of Compounding

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. The power of compounding — i.e., the act of generating earnings from previous earnings — is what makes any kind of tax-deferred investment a superb bargain. Let’s take a look at 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. Take a look at the table below to see what I mean.

An Example of Compounding in Action

I set up several different scenarios for the purpose of this table. All of them assume an 8% 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 2008), from the age of 15 to 70. Yes, I realize that 2008 was a disaster, but remember that the long-run average for stocks is closer to 10%, and we certainly aren’t done yet. Finally, the last 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.

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 almost $420,000 by age 60, simply by adding $1,000 a year to the account and achieving an 8% annual return. With larger initial (and subsequent) investments, you get even more bang for your buck. So the next question is: How can we get a teenager to save for retirement? </>

How to Get Started Saving for Retirement

I hope I’ve both made the benefits of funding an IRA clear, and simplified it enough that you can show this to your teens. But the question remains: How can we get a teenager to save for retirement? My advice: Help them. 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 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 also 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. It may be years, but eventually your children will thank you for your foresight.

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