2023 UPDATE

At what age should kids start investing?

Every financial guru is always asked the same question: “If you could change your past, what would you do differently?” Some would travel more, some travel less. Some would spend more time with family, others work harder. Etc.

However, one item is always the same: “I would start saving earlier”.

This is because of the magical power of compounding, also referred to as the Time Value of Money. If you get interest, then in the following years, you get interest on that interest, and then interest on that interest plus interest. . . and so on.

Considering the typical retirement age of 65, most of us get our act together (maybe) and start saving for retirement around age 35-40. That’s 25-30 years of compounding. Respectable.

But what if you could get 50 years of compounded growth?

You can.

Yes, start saving for retirement as soon as you have earned income

The best way to do this is to open a custodial Roth IRA account. This year (2019) any individual may contribute up to $6000 of earned income into an Individual Retirement Account (IRA).

If you are a minor (below age 18-21, depending on the state) your parents will have to open the IRA for you. This is called a custodial IRA. They will control your investments until you reach the age of majority, at which time the IRA is yours.

Many financial institutions offer custodial IRA’s. Two of the biggest are Charles Schwab and Fidelity. These two are also the highest-rated online brokers, according to Investor’s Business Daily. Both allow you to invest in virtually anything you wish. (I enjoy an account with both, but I’m not affiliated.)

IRA’s come in two flavors, the OG “traditional” IRA and the newer, sexier, Roth IRA. Both allow your savings to grow tax-free until you take the money out in retirement. The Traditional IRA gives you a tax deduction upfront, but when you go to take it out, you get taxed.

Roth IRAs work in reverse. You are taxed on the money you put in, but when you go to take it out, decades—or a half-century—from now, you are not taxed at all. In other words, all that interest you’ve made over the years is completely and utterly free of taxes.

Roth IRAs are perfect for teenagers (or arguably anyone) because 1) you have many many decades of growth potential, and 2) you aren’t paying a lot of taxes as a teen.

If you take money out of a traditional IRA before age 59½ you get hit with a 10% penalty. The money is intended for retirement after all.

However, if you take some money out of your Roth IRA, it most likely won’t be penalized.

The money that you contribute—that original $6000 per year—can be taken out of a Roth IRA at any time penalty and tax-free (as you’ve already paid the taxes). This is the money that comes out first.

Obviously, if you keep taking money out, you’ll dig into your earnings (all that interest), which will be penalized at 10%, and taxed as regular income.

Also, once you take that money out, you can’t put it back. This is for EMERGENCY ONLY.

Image by Jennifer Herrera from Pixabay

The magic of compounding over a long long long long long time

Based on an annual contribution of $6000, here’s how the numbers might add up:

How a $6000 per year IRA contribution compounds over decades. Total values rounded.

You could choose any return rate (interest rate), but I arbitrarily chose conservative returns of 3% and 5%. You could stop there: this is what you actually get with a 3% and 5% return, respectively.

However, we can’t forget about inflation (especially over 50 years!), therefore consider these to be inflation-adjusted rates. Since 1914, inflation has averaged about 3.2% (closer to 2% more recently).

• 3% is really ((1.03)x(1.032)-1) = 6.3% unadjusted
• 5% is really ((1.05)x(1.032)-1) = 8.4% unadjusted

In other words, if you prefer a diversified portfolio of stocks and bonds, a 6.3% return rate might be a reasonable target. Look at the “3%” outcomes.

For those heavily invested in stock, the S&P500 skews higher, so 8.4% may be more in line. Look at the “5%” totals.

Try this yourself at home using any annuity calculator.

Obviously, these are only estimates, as we don’t know what our future rate of return will be.

If we assume these return rates are inflation-adjusted, to make the math work, the $6000 annual contributions go up with inflation as well. It’s expected that you’ll be increasing your contribution every year as the limit increases. As you should.

Therefore, the “total” in the far-right column is the inflation-adjusted total.

With fifty years to save, that’s over 1.2 million dollars in today’s dollars.

In reality, with an 8.4% annual return, you’ll have almost five times more, but it will only be able to purchase what 1.2 million dollars buys today.

Fifty years from now, at 3.2% inflation 1 million actual dollars will only be worth a tad over $200,000 in today’s dollars. You’ll need five times what you think you’ll need.

How should you invest these savings? As you’re young and have many decades of saving ahead of you, you can afford to be very aggressive. Feel free to put the entire thing into a diversified stock portfolio.

(Tell your parents this, as they are making your investment choices for now.)

The easiest option is a stock index fund or exchange traded fund (ETF) that invests in all the stocks of a particular index, such as the S&P500. Alternatively, you can also invest in a “total stock market” index fund.

Photo by Skitterphoto from Pexels

Unfortunately, the lemonade stand doesn’t count

There is no age restriction on contributing to an IRA.

There is one big caveat, however. To contribute to an IRA, you are required by the IRS to have “earned income” for the year.

This is income reported on a W-2 form, which you get from working as an “employee” of an employer. Also, this income may show up on a 1099-MISC, which is income you may receive for being a “contractor”.

All states have their own child labor laws, but most follow federal guidelines which set the minimum age at 14. However, younger tweens can engage in “agricultural work”, deliver newspapers, perform as an actor, or simply work for their parents.

Unfortunately, most “cash-based” incomes that teens work for don’t count as earned income: babysitting, odd jobs for the neighbors, pet-sitting, etc.

(Side note: as an adult, if you work as a household employee as a babysitter, pet-sitter, etc. your employer is required to present you with a W-2, after deducting the usual social security and other taxes. There is no such requirement for household employees under the age of 18.)

If you have a *very* lucrative lemonade stand you can create your own business, report it all on Schedule C, and pay self-employment taxes. But I’ll leave that for your tax specialist to figure out.

Parents can help

As a parent, you’ll want your child to practice responsible saving at an early age. The $2000 that Junior makes at the ice-cream shop this summer isn’t much, and Junior will probably be tempted to spend it.

You can help Junior out by negotiating a “matching” arrangement. For every dollar that Junior saves in their Roth IRA, you can match 25 cents, 50 cents, or even the entire dollar. If Junior places their earned income into the Roth, you’ll give them a percentage of that amount to spend.

For example, if Junior decides to invest $1000 in their Roth, you might match them $500 in spending money.

There are no tax consequences of this gift. You—or any individual—may give any other individual up to $15,000 annually.

After matching Junior’s $2000, you can place the remaining $13,000 in a 529 account for Junior’s college. ($28,000 if there are two of you.)

Not only is Junior learning better savings habits, but they also have money for college.

And most importantly, they have the seeds of a Roth IRA that can potentially grow very very large, especially if they continue to contribute throughout their adult life.

Thinking about your future even ten years in the future is a challenge. Fifty years, almost impossible. (Will there even be “money” then, or will we all use to some complex cryptocurrency scheme…?)

But take it from your elder: save when you can, and as early as you can. It gets a lot tougher later.

Good luck!

Also, read:

• Roth vs Traditional. Picking where to stash your retirement money for the best tax-advantaged growth
• The Stock Market Doesn’t Make as Much as You Think it Does. Evaluating CAGR—compound annual growth rate—over the long term
• Invest Your Savings with Socially Responsible Funds. How to identify and evaluate ESG funds

First photo credit: Jill Wellington from Pixabay

This information has been provided for educational purposes only and should not be considered financial advice. Any opinions expressed are my own and may not be appropriate in all cases. All efforts have been made to provide accurate information; however, mistakes happen, and laws change; information may not be accurate at the time you read this. Links are included for reference but should not be considered an implied endorsement of these organizations or their products. Please seek out a licensed professional for current advice specific to your situation.