In the summer of 2004, my dad altered the course of my financial life when he handed me an article he’d clipped out of a local newspaper: “Roth IRAs – How to Give Your Child a Million Dollars”.
The author wrote that a Roth IRA (Individual Retirement Account) could be your child’s golden ticket to the millionaire club – all that was required was for the child to have earned income (see below for more details on how a Roth IRA works).
The earlier your child starts saving for retirement, the article continued, the better – allowing time for money to work for them via compound interest is an easy way to build a sizable nest egg.
The article proposed an example: investing $2,000 per year in the US stock market during the four years your child is in college (ages 18-22), and assuming an average annual return of 12% (on par with historical averages for the S&P 500 index), your child would have $1,000,000 at age 63.
To further illustrate the remarkable power of compound growth, consider a different perspective (this time using a more conservative assumption of 8% annual growth). In order to achieve a $1,000,000 retirement fund by age 60, you could invest
- $3,500 per year if you start at age 20 ($140,000 total investment)
- $8,000 per year if you start at age 30 ($240,000 total investment)
- $20,000 per year if you start at age 40 ($400,000 total investment)
Clearly, the difference in these strategies – to achieve the exact same outcome – is startling. The difficulty, of course, lies in convincing your child that setting money aside for later is more important that spending it now.
My dad practiced this basic financial discipline, and saw the Roth IRA as a no-brainer way to teach that discipline to his son. At the time, I was 18 and didn’t much think about what I would eat for dinner, let alone how much money I’d need for retirement. But a million dollars sounded good, even if I would have to wait a long time to put it in my wallet. So my dad drove me to a local bank and helped me set up my account.
Fast-forward 12 years: my Roth IRA and admiration for my dad’s wisdom have grown substantially
By starting my account and following the article’s prescribed contribution strategy, my dad gave me an enormous head start on retirement saving. He also schooled me on the virtues of prudence and temperance, in the form of financial discipline and delayed gratification.
Financial advisors commonly discuss the need to “pay yourself first” – in retirement, the only truly reliable source of income is the nest egg you’ve built up. If you want to teach this principle to your kids, however, simply saving for your own retirement won’t cut it. Setting up a retirement account that is their own, however, could be the key. You’ll literally be putting your money where your mouth is.
It might seem impossible to do this for yourself, let alone your children. Maybe you’re facing college debt, a mortgage, car payments, and your kids’ college tuition. Perhaps building an emergency fund, tithing, or simply managing everyday expenses with a growing family take priority.
My point is not to diminish these very real and very serious financial obligations, but rather to highlight the power of compound interest. Waiting until you “have enough to save” would mean investing exponentially more money to achieve the same goal. Most financial institutions require small (typically less than $100) contributions to open an account – even $50 can help your kids understand the importance of saving early for retirement. Teaching your child how to save will cultivate in them the discipline to think about what kind of car they’d like to drive when they’re 65, not just when they’re 25.
Ultimately, ignoring the power of compound interest might mean living with less financial freedom (e.g. working longer). Teach this lesson to your children. Help them understand the importance of saving early. Encourage them to form a saving habit. A Roth IRA isn’t the only way to do this, but it is uniquely suited to the job.
I’m forever grateful to my dad, and I hope to pass along his wisdom to my own children. Thanks Dad! Enjoy your retirement.
Here’s how a Roth IRA works
- The only minimum requirement is that the beneficiary must have earned income; no minimum age (an adult must control the account for a minor under 18)
- Maximum annual contribution is $5,500, not to exceed the beneficiary’s annual earned income (e.g. if income is $2,500, then the maximum contribution is $2,500)
- Minimum contributions to set up an account vary by financial institution, but are generally less than $100
- Contributions are made with after-tax money; earnings grow tax-free
- Contributions can be made by someone other than the beneficiary (e.g. parent, grandparent)
- Withdrawals after age 59 1/2 are tax-free; withdrawals before age 59 1/2 incur a penalty