September 2013
Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
Small steps to building wealth and financial security apply to children, as well as to adults, perhaps even more so because they have time on their side to save and invest for half a century or more. Thus, it is possible for a child to become a millionaire, indeed a multi-millionaire, by investing in an individual retirement account (IRA) at an early age. The magic of compound interest over five decades (e.g., age 15 through age 65) is positively awesome and can turn even small regular deposits into a substantial nest egg for retirement.
The only “catch” is that children, like IRA depositors of any age, must have earned income from a job or self-employment earnings to invest in tax-deferred accounts. Gifts and allowances don’t count. Children can make an annual IRA contribution of up to $5,500 (in 2013) or the amount of their annual earnings, whichever is less. For example, if annual earnings total $1,800, that is the cap on IRA savings deposits.
In addition to paid employment, many children earn cash payments from activities such as lawn mowing, car washing, newspaper routes, snow shoveling, and babysitting. Keeping a simple log of the date and payment for these activities (e.g., April 30, lawn mowing for Mrs. Smith, $25) is recommended to provide proof of earned income in the event of an audit. So-called “Head Start IRAs” can begin as soon as a child has received any sort of income, perhaps as early as age 10 or 12. If parents own a business, opportunities to hire their children may also be available (note: be sure to pay a reasonable wage to avoid IRS scrutiny).
The reality, of course, is that most children who struggle to earn $500 or $1,000 over the course of year aren’t about to lock up their hard-earned money in an IRA for 50 years. That’s okay. Their parents or other benefactor can fund an IRA to the extent of a child’s earnings. For example, if 17-year old Susan earns $1,000 and has other plans for her money, her grandfather could put up to $1,000 in an IRA in Susan’s name.
The growth of an IRA over five decades is phenomenal. Several examples were provided in an article in Mutual Funds magazine years ago. If a teen (or someone on their behalf) contributed $2,000 to an IRA for just five years from age 14 through 18, they’d have almost $1.2 million at age 65. If an even younger child contributed $500 at age 8, $750 at age 9, $1,000 at age 10, $1,250 at age 11, $1,500 at age 12, $1,750 at age 13, and $2,000 from age 14 to age 65, they would have over $4.2 million. These examples assumed a 10% average annual return which would require investments in stock over the decades. The average annual return on stocks since 1926 has been about 10% with lots of ups and downs in shorter time frames.
Here are two final thoughts about long-term IRA investing. First, children and young adults should consider funding a Roth IRA as a long-term investment vehicle for retirement. Tax deductions on a Traditional IRA are generally of little consequence at a young age in a very low tax bracket compared to the appeal of tax-free withdrawals, later in life, of money that has accumulated earnings over 50 years.
Second, the impact of earning a higher return (e.g., 10% instead of 7%) and paying lower investment expenses over time should not be underestimated. A long time frame, attractive investment yields, and low expenses (e.g., a 0.20% expense ratio on a stock index fund vs. a 1.5% ratio on an actively managed fund) can provide young investors with a priceless advantage: the potential for financial independence.
Small steps do matter! Even small amounts of money can grow to significant sums given sufficient time to grow, preferably in a tax-deferred investment with low expenses. A child that starts setting money aside at a young age is more than a young saver. He or she is a millionaire in the making!