Fund a Teenager's Million-Dollar Retirement

The following is a guest post from Marotta Wealth Management.

I (FMF) have started this process with my children. They earn (soccer for my son and pet sitting for my daughter) and I contribute the amount they make into a Roth for them.

We teach teenagers a lot more about sexuality than we do about money. This can confuse them about what they should be learning. Give this article to a teenager and encourage him or her to start a Roth IRA.

For a $4,300 gift spread out over the next seven years plus a little work on the teenager's part, you can fund a teenage child or grandchild's million-dollar retirement. Here's how it's done.

Teenagers can contribute to a Roth IRA to the extent they have earned income. Getting earned income does require some work on their part. They need to keep track of everything they earn. The work has to be real, and the income needs to be reported on their tax form. Many young people long to do real work. Our children began doing paid work at age 14.

Earning money is hard work. But it teaches vocational skills that many college graduates still have not learned. Working teaches adolescents to speak standard English clearly so they can be understood. They learn to communicate with adults in a respectful way. They find out how to plan ahead so they arrive at their job on time and prepared to work. On time means five minutes early, not thirty seconds late. They discover how to take self-improvement and learning skills seriously, improving their self-esteem in the process. And finally, they learn to follow both the letter and the spirit of instructions.

The skills and life lessons that teens gain in early work situations can create just as much if not more satisfaction and self-confidence than doing well in school. And the experience will inspire them to put more effort into their education and perhaps value it more too.

But having finally earned some of their own money, few teenagers want to contribute it all toward their retirement, which to them may seem like an unreal event in the distant future. That's where a parent or grandparent can supply the right incentives. As a powerful motivator, you can offer to fund their IRA with an amount equal to whatever they earn. For example if they earn $615 during the summer, you will give them an additional $615 to fund their Roth IRA. They will work hard to fund their IRA and still have money to spend. It will be well worth the joint family effort.

Contributing $615 each year for seven years and earning 11% will translate to investments worth a million dollars at the end of 56 years. If the process begins at age 14, the value of the Roth IRA will reach a million dollars at age 70.

Starting early makes a huge difference. At the end of the first seven years of saving and investing $615 a year with an 11% rate of return, the portfolio should be earning and reinvesting over $615 per year without any additional contributions. Funding a Roth IRA for 7 years and then stopping actually results in more money than waiting 7 years and then funding it with the same annual amount for the rest of your life. The difference gets more pronounced the longer you delay. Thus contributing $615 between ages 14 and 20 and then stopping is more profitable than starting at age 40 and contributing the maximum $5,000 a year until age 70.

Teenagers are not restricted to $615. The limit for 2012 Roth contributions is $5,000. You must decide how much incentive you can afford to help raise a financially savvy child. Sometimes all the private education and tutoring doesn't do as much good as practical work experience at helping motivate and empower young people to take charge of their own destiny.

Earning $615 only requires working for 82 hours at the $7.50 minimum wage. There are about 360 working hours during the two-month summer vacation. At $14 an hour all summer, an industrious teen might earn more than the $5,000 maximum Roth contribution. So be sure to determine ahead of time how much you are willing to match before offering the incentive of doubling their pay if they contribute to a Roth.

Offering to match their funding with a gift is generous and provides a great incentive for them to plan and save for their future. But families with less income can mentor their children through the process without matching their contribution. A financial planner can help set up the accounts, manage the investments and explain the principles of the plan.

Contributions to a Roth account are made after paying tax. If your taxable income is less than $8,700, you owe no tax. Therefore your teenager can put money into a Roth account without paying tax on it. All the appreciation is tax free. And withdrawals in retirement, even withdrawals from a million-dollar portfolio, are also tax free.

Contributing to a Roth account while you are young and your income tax rate is minimal is tax-planning genius. This is a rare opportunity to not pay tax on money and put it where it will never be taxed again. Later in life it will be more difficult to contribute to a Roth account as your marginal tax rate rises. Receiving tax-free growth for life is an added perk of funding your Roth account while you are younger.

Much of what is true for a teenager is true for adults as well. Unless you are at the peak of your income-earning potential, funding a Roth might still be brilliant. And leaving a Roth IRA to the next generation is estate-planning genius because it leaves the next generation a tax-free income for life.

Children need practical experience working, earning, saving and investing. Give them all four, and help them fund their retirement in the process. It may just spark the entrepreneurial spirit in the next generation. Can you afford not to?

Comments

[William @ Drop Dead Money]

What an awesome idea!

Money aside, just to have your parents teach (and model) savvy life skills, and creating a platform for functional communication, is worth millions right there.

[Lance@MoneyLife&More]

Very cool idea but more importantly, where can I get an 11% return for 56 years? If I can do that I can retire much earlier than I am currently anticipating. Honestly I find that unrealistic, but I wouldn't complain if someone can show me the way to do it.

[DIY Investor]

I agree that work is valuable for young people. In fact, I see many community college students to whom arriving on time is an unknown concept.
I recommend waiting tables. Then all the skills - dealing with the public, taking down information, completing a task in a satisfactory manner come into play. Furthermore, with the experience a person can get a job anywhere in the country and have tip money in their pocket that night.
Although I like the idea of starting a Roth I wouldn't focus on it. I would suggest an "education financing" talk and strategizing on how the teenager will finance education.
I see too many young people in la la land when it comes to costs of education and what they can expect to earn with their degree.

[FMF]

Lance --

Who knows what the future will bring. For a teenager who has 40 years (or more) to invest, perhaps 11% is attainable. But there are no guarantees, of course.

That said, I understand the point. Marotta is still in the Dave Ramsey "too high" category when it comes to predicting future returns IMO as well.

[Luis]

@ Lance Some people can do it through brokerage accounts. But yes it takes active trading and knowing the markets. Incidentally, Mitt Romney has over $100 million in his IRA, which would have him averaging just over a 16% yearly return.

[Lurker Carl]

I assume Mitt dumped a 401k or two into his IRA to reach that lofty sum.

No single investment can earn 11% per year for decades without active management. Doubling every 6.5 years will eventually consume all the wealth on Earth.

[SR]

"No single investment can earn 11% per year for decades without active management. Doubling every 6.5 years will eventually consume all the wealth on Earth."

11% returns might be hard to find but the foregoing statement is ridiculous. "Consume all the wealth on Earth"? Really? Not every transaction is a zero sum game. Further, perhaps there is more wealth on earth today than there was in 1980? The wealth pie is not fixed it's expanding.

[Jake]

Assuming we invest $615 for 7 years and let it compound for 49 years (our 14 year old is age 70 at the end), you would have these account balances at varying rates of return:

1% - 7,296
2% - 12,306
3% - 20,658
4% - 34,520
5% - 57,421
6% - 95,088
7% - 156,776
8% - 257,373
9% - 420,734
10% - 684,929
11% - 1,110,474

Assuming our 14 year old put in $5k for 7 years, the 5% return on average would get them $466,838 and over $1.2M at 7%. 11% returns would have an account balance of over $9M.

Assuming inflation of around 3%, $1M today would be roughly equal to $4.7M in 56 years.

Regarding the IRA that Romney has, from the WSJ:

"Bain Capital, like many other private-equity firms, allowed employees to co-invest in its takeover deals. This posed a risk they could lose their whole investment, as they sometimes did. But because of the firm's success during the Romney era, employees ended up able to share in returns for Bain investors that averaged 50% to 80% annually.

Bain added a couple of unusual twists that made co-investing even more rewarding. It allowed employees to co-invest via tax-deferred retirement accounts, and to do so by buying a special share class that cost little but yielded much larger gains than other shares when deals proved successful, according to former employees and internal Bain documents analyzed by The Wall Street Journal.

In one particularly successful deal, Bain increased the equity value of a company it had acquired by 36-fold in 20 months. But some Bain employees saw a 583-fold increase over the same period on IRA money they invested in the special share class of that company. Being in an IRA, the gain could then be rolled over, without initially subtracting taxes, into fresh Bain deals, for years of compounding.

Bain's co-investment arrangements, not previously reported in detail, offer a possible explanation of the large size of Mr. Romney's IRA: between $20.7 million and $101.6 million, according to his finance disclosures."

[Jim D]

How does money in a child's Roth impact financial aid for college?

[FMF]

Jim D --

"Some parents use a Roth IRA to give their children a head start on saving for retirement. The parents set up a Roth IRA in the child's name and make contributions to the Roth IRA up to the amount of the child's after-tax income (or the annual contribution limits, whichever is less), often as a gift. Assuming the Roth IRA has a 10% return on investment, a $1,000 contribution at age 15 translates into $117,400 tax-free by age 65. So contributing up to the limit from high school through college could provide the child with a well-funded retirement plan even if they use fairly conservative investments. Since the money is in a qualified retirement plan, it has no impact on aid eligibility if the student does not take any distributions while they are in school. The contributions also do not affect aid eligibility since they are made with after-tax dollars."

Source: http://www.finaid.org/savings/retirementplans.phtml

[Jim D]

Thanks FMF,
I think it is important to stress that if a child does take distributions while they are in school it can affect aid eligibility. A student on a partial ride might tap their Roth to avoid taking on student loan debt, but doing so could disqualify them for financial assistance the next school year.

[retirebyforty]

I'm planning to do this for my kid when he starts earning some money. It's good to see that the Roth IRA account will not impact financial aid.
11% is going to be tough to do. My Roth IRA did pretty badly over the last 10 years.

[Jeff]

"For example if they earn $615 during the summer, you will give them an additional $615 to fund their Roth IRA."

Great! I can teach my child that $615 (earnings) minus $615 (buying stuff I really want!) = $615 (Roth investment). It's so very American to have your cake and eat it too!

I guess that you'd have all your ducks in a row if the IRS came knocking, but is that $615 really earned income? I truly appreciate the sentiment, but I'd suggest that these aren't the best financial and ethical lessons to be teaching your children.

[Jim D]

Jeff,
I have to disagree with you.
Financially and ethically, how is the matching here really different than employer matching in a 401k? The matching is used to influence behavior, otherwise a child might have no interest in earned income and choose to settle with an allowance.
And as a financial lesson goes, when your child is 18 or 20, you point to the Roth balance and ask what they have to show for the hard earned money they spent, perhaps frivolously. I think that is a great way to demonstrate the benefit of saving vs spending (probably too early to see a lot of compounding).

[Old Limey]

Here's my record over the first 15 years of my retirement.

1993 82% - Emerging Markets took off, FEMKX alone had Ann=81.33%
1994 2.5%
........................................................
1995 20.36% - Start of the dot.com bubble
1996 11.06%
1997 27.41%
1998 41.97%
1999 61.63% - Gain this year was more than my gross salary over 32 years as an aerospace engineer
2000 29.79% - The dot.com bubble burst in March 2000
........................................................
2001 5.03%
2002 2.03%
2003 27.37%
2004 7.64%
2005 4.12%
2006 17.51%
2007 5.11% - From here on I went into only income investments

Total gain over 15 years = 1,690%
Annual percentage gain over 15 years = 21.22%

For the S&P500
Total gain over 15 years = 237%%
Annual percentage gain over 15 years = 8.44%%

I was using very active fund selection and market timing throughout. I never had a losing year - just one large losing year can devastate your longterm performance, and must be avoided at all costs.

Even with an outstanding year for emerging markets in 1993 plus the "Once In A Lifetime" DOT.COM bubble my 15 year average return was 21.22%. Thus I consider it impossible for the average investor that is working full time to make an average return of 11% over a long period.

This is particularly true when you consider America's budget deficit, huge national debt, weak economy, 46.4 million on food stamps and 13 million unemployed. To say nothing of its huge unfunded liabilities for SS and Medicare, while still waging war, handing out foreign aid all over the world, and with a very bloated defense budget.

[FMF]

Old Limey --

I think those greedy defense contractors are responsible for the "bloated defense budget." You wouldn't happen to know any of them, would you? :)

[Bo Manry]

I really like this post. It is so important to teach our kids the importance of work. It doesn't matter how well off we are as parents, the value of learning how to work is necessary.

[Nicole C.]

I think it is one of the greatest gift the parents can give to their child(ren). Baby boomers haven't saved much for retirement (can't really blame them though; they are depending on IN-DANGER social security & pension and 401k was relatively new to them) Then, my peers (generation y) know we need to start early and save more for retirement but we are trapped to payoff the huge amount of student loans. Contribute to children's roth IRA will let them be ahead of the game.

[Kelly@FinancialBailoutNews]

Like the college post from a few days ago about keeping the end in mind, I think its wishful thinking to tell young people (especially teenagers) about doing something today that will benefit them 50 years from now. Remember what it was like being that young? Your instant gratification monitor is on in full force, and its almost impossible to consider how doing something now will benefit you when your old. The only way this idea will work is if kids are forced to save this money by their parents, and use it as a "have to" sort of account, rather than a "should".

[Jeff]

Jim

Of course I understand the incentive aspect of this scheme, and certainly I would want to incent my kids to save for long-term goals like college and retirement. My parents couldn’t afford to adopt this type of scheme for my three siblings and me, and yet we’re all financially independent now. My family certainly wasn’t poor, we just didn’t have an excess of discretionary income.

In answer to your question about 401k matching: My employer doesn’t give me unrestricted, tax-free money to buy that sweet iPad that I really want. They match the money, to a degree, of EARNED money that I contribute, and it has to stay in the 401k. As far as I know, you can’t do that in a Roth IRA; if the kid makes $615 the whole year s/he can’t contribute $615 + 5% to his/her Roth. Also, there’s a huge difference between the typical 5% employer matching and the 100% parent matching in this post. I just don’t want my kids to start believing in the entitlement fairy. And let’s be honest here about the ethical question, what really happens in the majority of cases is that the kid spends the $615 s/he earned on the iPad while the parent contributes unearned $615 into his/her Roth.

[celgans]

This is a great article. The discussion should not be on whether to incentivise the kid or not, as it seems to be happening on this forum, nor should it be on whether one can acheive 11% returns or not. For one, its your choice, save/donot save, with/without incentive. 2ndly, please tell where you can get any returns better than a tax advantaged Roth anywhere else?
Be that as it may, could someone please explain to me, aren't the following two statements paradoxical; "1. The work has to be real, and the income needs to be reported on their tax form" and "2. If your taxable income is less than $8,700, you owe no tax."
In other words, if the kids income is not reported because it is less than the taxable amount or if its reported on the parents return, this scheme cannot work?

[FMF]

celgans --

Here's what I think the case is for those statements:

1. "The work has to be real, and the income needs to be reported on their tax form."

It has to be work that actually occurred -- like my son working as a soccer referee. It can't be made up (fabricated) just so a contribution can be made.

The income must be reported on their own tax form -- not on their parents' form.

2. "If your taxable income is less than $8,700, you owe no tax."

Not sure what the problem is here. You can report any amount of income -- even an income where there's no tax due. Something that's reported can either owe taxes or not owe taxes. Whether it is one or the other has no impact on whether you can contribute to a Roth or not.

[Lurker Carl]

SR - Exponential growth is always doomed to crash. Roman Empire, housing and .com bubbles, bacterium on agar in Petri dishes are proof.
Here's the math:

At 11% annual growth, $4000 becomes one BILLION dollars in 113 years.

Since this is for the children, put the funds in a generational skipping IRA. If several million or so other folks do the same thing with the same investment scheme, all the wealth on Earth is bound up in these IRAs within a few generations. So either we are dreaming the impossible dream or inflation has diminished that "wealth" by many orders of magnitude.

[Catherine]

Oh, look, one more formula for getting rich where A + B + C = a Million dollars, where A = save some money.
B = wait a while. In this example wait half a century.
C = be lucky.

Because seriously, if you earn 11% annual return for the next decade ( and the four decades after that) you are very lucky.

I don't mean to imply funding your own IRA as soon as you start working is a bad idea. It's a great one. And any parent funding their own kid's retirement at the expense of their own is a fool. But the two biggest inputs here are time and luck. And you will need an awful lot of each.

[Old Limey]

@FMF
Working for a defense contractor during the Cold War was patriotic in my opinion. Remember when the Soviet Union and the Free World had thousands of nuclear missiles deployed in submarines, bombers, missile silos and mobile missiles, large cities had signs pointing to the best escape route from the city if the threat escalated to the highest level and people were building their own bomb shelters.

I retired just after the Berlin Wall came down and the USSR and its satellite countries broke apart. Since then it is my opinion that the only two wars that were justifiable were the Kuwait War and the Bosnian/Serb war. All of the others should have never been waged and the defense budget should be much smaller today.

[08graduate]

@Lurker Carl

I think most people agree with you that 11% real growth is not a reasonable expectation. However, 3% average growth in real global GDP has been a reality for a very long time. That's still exponential!

http://www.google.com/publicdata/explore?ds=d5bncppjof8f9_&met_y=ny_gdp_mktp_cd&tdim=true&dl=en&hl=en&q=global+gdp

Capital enjoys a risk premium relative to labor, so it _is_ possible for investment returns to outstrip overall growth indefinitely. A 5.5% or 6% real return on stock investments in the coming decades seems like a safe, conservative guess to me. Of course, I'm on the bullish end of the spectrum. Here's the smartest bear on the planet, Bill Gross of PIMCO, making a well-argued case for 4%:

http://www.pimco.com/EN/Insights/Pages/Cult-Figures.aspx

So, 4%? Still exponential! In a pedantic sense, you're right: all exponentials hit a limit eventually. I'd love to hear concretely why you expect the ceiling on human prosperity is imminent.

[08graduate]

Correction, Gross argues for 1%. Still exponential!

[FMF]

Old Limey --

I was just teasing you... :)

[Lurker Carl]

08graduate - Actively managed portfolios can do better than the S&P500 index fund yet most do not. Active manangement is expensive and a lot of work for an account with few thousand dollars, and no guarantee it will keep up with inflation over 50 years.

Governments world-wide are dependant upon inflation and zero interest rates to tame massive debts. Industry as a whole does not prosper in such conditions and it is destined to continue. Our economic advisors and experts have painted themselved into a corner. One decade lost, more to go.

[Old Limey]

@Lurker Carl
You're right that actively managed portfolios can do better than a portfolio of ETFs that follow market indexes.

However if you only want to play the long side of the market as I used to do you still need to have some market sectors that are greatly outperforming the market averages. During the dot.com bubble it was companies involved in computers, electronics, networking, and internet retailers that were soaring. At other times it was real estate, banking, energy, and emerging markets. However since the great recession started it's hard to find any exceptional market sectors.

Prior to the spread of the internet I used to do very well playing the Fidelity Select Family, a 42 fund family where each fund represents a different sector of the market. These funds had a short term redemption fee of 3% if you held them less than 30 days. However once the internet took off, a lot more investors started playing the "Selects" and sector rotation started speeding up to the point where it was difficult to hold them 30 days without losing money.

Playing the short side of the market can be very lucrative at times but it involves far more risk. If you buy a stock the most you can lose is what you paid for it. However if you sell short a stock there is no limit to how much you can lose. I tried selling short on 2 or 3 occasions and never made money at it so I gave up.

It wasn't a lost decade, it was actually a lost 13 years and I don't see it improving anytime soon.
The S&P500 has lost 0.23% between 7/16/1999 and 8/16/2012, while I made 290.73%.

As for exponential growth - it works great as long as you don't have losing years. Throw a few years with 50% losses in the mix and you will get a very different result, especially if they occur in the later years.

[ParatrooperJJ]

As long as a W-2 or 1099 is issued in the kid's name then you have leagal earned income.