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 10 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.
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.
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 IRA 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.