When Michelle Brownstein started a summer job at an apparel retailer in the late 1990s, her father made the then-teenager a deal: If she agreed to save a portion of her earnings in a Roth IRA, he would match her contributions.
In doing so, Brownstein’s dad explained, she would be able to stash away savings at a very low tax rate; benefit from decades of compounding; and, eventually, withdraw the money free and clear.
“I didn’t fully grasp the benefits of a Roth back then, but it got me on a path to saving and thinking about investing at an early age,” says Brownstein, who is now a certified financial planner and vice president of private client services at Personal Capital. “I still have that Roth IRA.”
Indeed, setting up a Roth IRA for your children—or your grandchildren —might be the single best thing you can do to help jump-start a kid’s long-term wealth and, along the way, teach invaluable lessons about saving and investing.
First introduced in 1997, the Roth IRA lets you save up to $6,000 a year in after-tax dollars, then enjoy tax-free growth and tax-free withdrawals after age 59½. While there are many benefits of putting money in a Roth IRA, the strategy makes a lot of sense for people who are in a lower tax bracket today than they expect to be in retirement.
For most teenagers, it’s a no-brainer because, unless they have exceptionally lucrative side gigs, they pay very little if any taxes on their earned income.
Even if your teen doesn’t get excited about the nuances of tax arbitrage, she can probably appreciate the power of compounding if you walk through a basic savings calculator. Here’s a fun stat: Someone who saves $6,000 a year starting at age 15 can accumulate more than $1 million by the time she turns 60, and that’s assuming a very modest 5% return.
Parents can sweeten the deal to save for retirement
One big caveat to this strategy is that teens need to have bona fide earned income to qualify; cash from mowing lawns and babysitting doesn’t cut it. Assuming they have W-2 or 1099 earned income, however, they can then contribute up to the $6,000 maximum allowed by the IRS or the equivalent of their earnings, whichever is lower.
The other caveat is that convincing a teenager to save a huge chunk of her summer paycheck for retirement is typically a tall order. To sweeten the deal, parents can do as Brownstein’s father did and offer to supplement a portion of savings. For example, if your teen earns $3,000 a year, you could offer to match her $1,500 contribution – making it possible for her save the maximum allowed while still having $1,500 left to use as she chooses.
And teach invaluable financial planning lessons along the way
Even if your child manages to save just $1,000 a year in a Roth, getting a young person on the path to thinking about saving regularly can pay dividends as they move into adulthood.
Not only is it a great way to establish a habit of long-term saving, it’s an opportunity to teach a kid about the basics of investing and give them the confidence to make financial decisions. “My dad and I sat down on a regular basis to talk about what I wanted to buy,” Brownstein recalls.
Picking individual stocks is a great way to spark enthusiasm for investing, and make the process a little more tangible. As the account grows in value—and your kid begins to better grasp the concepts of risk and return—consider adding a low-cost index fund or exchange-traded fund, such as an S&P 500 index (.SPX) fund.
For example, you might aim to put 90% of the Roth IRAs assets in a fund and earmark the remaining 10% for individual stocks. If an idea is a bust it won’t wipe out a kid’s savings—but it could be a great teachable moment in the value of diversification.
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