As we all hurry to fund our year-end retirement contributions to our Roth or traditional IRAs, we all need to keep in mind the future generation.
That’s right: our kids and grandkids. Do I sound crazy? My teenager thought so! Especially after I suggested he save in a Roth IRA a percentage of what he earned at his part-time job. But once I showed him how much he’ll have by the time retirement rolls around, he was all for it.
By matching my son’s summer earnings and putting the money away in a Roth IRA, my son had already built up a tidy savings of $18,000 by the time he was 23!
So, if you’re looking to send your kids down the path of prosperity, now is the time to tote up what Junior earned throughout the year and open a retirement account for him before the April 15 deadline.
Helping Junior Get a Jump on Retirement
The Roth IRA is an excellent retirement savings vehicle for the next generation. 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 distributions upon reaching the age of 70½ and paying federal taxes at your future — and possibly higher — tax rate. (To learn more about the tax implications of your own retirement, you’ll want to read “Top Tax Strategies for Retirement.”)
What’s great about a Roth is that you can invest with after-tax dollars now, and your child can withdraw funds tax-free after the ripe old age of 59½! Once he hits retirement, there is no requirement on distributions — if he doesn’t feel like taking money out, he can leave it in there to continue growing.
But here’s the real added bonus for your teenager: taxes and the power of compounding.
If your children are 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 is what makes any kind of tax-deferred investment a superb bargain. What do I mean by compounding? The definition of compounding is the act of generating earnings from previous earnings. Confusing? 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.
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!
How to Get Your Teenagers to Think Ahead
I think I’ve made the benefits of retirement planning clear, but the obvious question remains: How can we get teenagers to save for retirement?
My advice: Help them. That’s what I did with both of my kids.
Let’s assume you can afford to match their summer earnings. 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 they won’t bring it all home. That doesn’t keep you from putting a full $1,000 into a Roth for them.
Perhaps you can’t afford to add the full amount. Then consider making a deal with your teen to match a portion of their earnings that they add to the Roth. Let’s say your teenager contributes $250, maybe you’ll contribute $500. (Grandparents: This makes a great gift for the future generation.)
In fact, helping your teenage child or grandchild on the road to a secure retirement is truly one of the best gifts you can make, and one that will keep on giving year after year. Now’s the time to do it, before the April 15 deadline for this year’s contributions passes. It might take years, but eventually your child will thank you!
Looking for more ways to help you (and your teen) save for retirement? Then check out the March 2008 issue of Dan Wiener’s The Independent Adviser for Vanguard Investors! In “Teeny IRAs” Dan shows you the steps you need to take now to make sure your child is on the path to a golden retirement!