By Daniel Trumbower, CFP
Does your teenage child have a part-time job? How about earned income? If so, their job and earned income could help them do more than just buy their first car or help out with college tuition. You and your child could use their income as an opportunity to get them on an early path to becoming a millionaire through the use of a Roth IRA.
Because the IRS allows anyone who earns taxable income to contribute to a Roth IRA, your child can start stashing cash for retirement at an early age. Of course, teenagers aren’t thinking about retirement. That’s a lifetime away! But you know the power of saving early and often can help put them on the path to financial independence. What greater gift is there than helping your child succeed?
How to Become a Roth IRA Millionaire
Let's assume your 14-year-old starts a job and earns a modest $1,000 (before taxes) by the end of the year. This is probably reasonable considering most states restrict the number of hours minors can work to encourage a primary focus on school.
Roth IRA stipulations currently let you contribute either $6,000 (maximum for 2021 under age 50) or your gross income (whichever is less) to a Roth IRA. In this case, since your child only earned $1,000, then $1,000 is the maximum that they’d be allowed to contribute. It may be helpful to know that parents and relatives can also contribute to the Roth IRA on the child’s behalf as long as the total contribution does not exceed the IRS limits (in this example: $1,000).
Let's say you and your child continue this trend for the next three years of high school until age 18. If their Roth is invested in a stock market index fund that produces an average return of 10 percent per year, then their total contributions of $4,000 would be worth $4,440 when adjusted for 3 percent inflation.
After high school, we’ll assume they’ll be able to work more hours and save up to the full $6,000 maximum. If they continue to save the maximum $6,000 throughout adulthood, then they could stand to hold the equivalent of $1,000,000 in today’s dollars by the time they reach age 55.
Since Roth IRA earnings can't be withdrawn without penalty until age 59 ½ (unless they meet specific criteria such as disability, costs related to birth/adoption, qualified education expenses, etc.), we can further theorize that they work another 5 years until they're age 60. By this point, their portfolio would have an inflation-adjusted value of $1,459,913 (or $3,479,980 nominal).
How Compound Growth Helps Your Money Grow
If you were to add up all of your child’s contributions, they would have only totaled $256,000. So then where did the other $1,203,913 come from? The “magic” (as some call it) of compound growth.
Compound growth is the phenomenon that occurs when money grows on top of both your contributions plus any previous earnings. As the pool of money gets larger, so does the potential for any future growth. It’s an exponential relationship that explains why investing early and often is just so powerful.
Keep in mind, compound growth is most efficient when two things happen. The first is that you invest in securities that will maximize your return potential. Equity-based mutual funds and ETFs (exchange-traded funds) are ideal because they will have the best chances of producing the highest returns over the long term.
The second is that you get started as soon as possible. Encouraging your child to start a Roth IRA as early as age 14 will give them a significant, 10-year head start over their peers.
To put this into context, let’s say your child has a friend that doesn’t start using a Roth IRA until age 25. If they started contributing $6,000 per year and invested in the same stock market index fund, then their account would have a real value of $893,481. That’s 39 percent less than your child’s Roth balance.
Why Use a Roth IRA?
Roth IRAs are uniquely suited for younger savers, especially teenagers who are just starting out, particularly because of the way Roth IRAs are taxed.
Recall that with a Roth IRA, contributions won’t reduce your taxable income and you’ll effectively pay taxes on them for that year. This means that ideally you’d want to be in the lowest marginal tax bracket possible. What better time to do this than when you’re a teenager and only earning a few thousand dollars?
The advantage is that all of their earnings will be tax-free in the future. Assuming the tax laws don’t change between now and when your child retires, they will be able to withdraw as much of that $1,459,913 portfolio without any of it counting towards their taxable income.
Additionally, they won’t have to worry about taking any RMDs (required minimum distributions). Anyone saving for retirement using a traditional IRA or 401k will be required by the IRS to start taking RMDs starting at age 72, or face a hefty 50 percent penalty on the required distribution amount.
Roth IRAs can also serve as a helpful backup emergency fund. Because the contributions to a Roth IRA have already been taxed, account owners are allowed to withdraw their contributions any time they wish. It’s the earnings portion of the Roth IRA that are subject to taxes and penalty through age 59-1/2.
Though it’s best to leave the money untouched until retirement, it can be helpful to know that you’ve got a potential pool of money you can dip into if you were ever faced with a true financial crisis.
About the author: Daniel Trumbower, CFP®
Dan Trumbower, CFP®, is a Senior Wealth Advisor at Halpern Financial, a fee-only, independent, fiduciary wealth management firm in Rockville, MD and Ashburn, VA. Dan received a BSBA in Finance from Coastal Carolina University, and is a CERTIFIED FINANCIAL PLANNER™ professional and has special expertise in financial issues affecting key executives of large corporations (such as restricted stock awards, incentive, and non-qualified stock options along with NUA (net unrealized appreciation) distributions from employer savings plans).
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