Roth IRA for a Minor Child
Last week we went over my 5 favorite ways to save for minors, where I highlighted several different options to help you save for the minors in your life. Today, we’re only going to talk about one product, the Roth IRA. I’ll give you a little background on Roths, some of the perks and limitations, and how you can implement a Roth as part of your family’s long term savings plan. Let’s get started!
Quick History of the Roth IRA
The Roth IRA is relatively new. It was originally proposed in 1989, and finally found footing as part of the Taxpayer Relief Act of 1997. The plan is named for senator William Roth, one of the two senators who sponsored the plan. At its inception, the annual contribution limit was only $2,000. The limit has since been increased to $6,000, which is good news for anyone looking to grow their savings tax-free!
So just to recap from last week, a Roth IRA is a great long-term savings vehicle for people looking to put away money for a long time. While you CAN pull out the principal anytime, the growth from every dollar is tax free, forever. So this is a place you want to put money you don’t see needing until retirement.
Start early
A Roth is typically the very first savings account I recommend for everyone under the income threshold, especially children. Because the money grows tax free, and the annual contribution limit is only $6,000, I always recommend that the first available $6,000 someone has to put away each year go into this account. The caveat is that this money must be earned income. For children, this might get a little tricky, since a 3 year old can’t reasonably make $6,000 in a year. But any money a child is eligible to earn can be put into this account. Now, the kids I know, they want to take any money they get and go spend it at the store. My kids used to be like this too. But then I started expressing money in different terms, and it was incredible how quickly their attitude towards money changed. Full disclosure, I’m still working on my 6 year old, so if your little one is still more enamored by a trip to the store, perhaps you can bargain with them to split the money in half, take some to the store, and save the rest.
Example #1 - Earn more to get paid later
I’ll give you a great example of how you can explain this to a child. I have a boy on my street named Oliver. He’s 9 years old. This kid is so industrious, he’s always doing something; raking leaves, shoveling snow, gathering wood, you name it. My yard had a bunch of sticks that had come down from the trees over the winter. I wasn’t looking forward to bending over 200 times to pick them up, so I asked Oliver if he wanted to earn $5. He said, “Sure!” I told him what I wanted done, and he got to work. He spent about 30 minutes picking up all the sticks in my front yard. When he was done, I asked him to go get his Mom. When his Mom came out, I asked Oliver, “Ok, do you want $5, or $275?” Well, he looked at me like it must be a trick question, so I asked him again, would he rather have $5, or $275 for the same amount of work? He said, “$275”. I told him that was a good answer. Then I explained that in order to make this $5 turn into $275, he would need to ask his Mom to open a Roth IRA for him and put that money in there to grow. I told her that it had to be earned income, and since he was young, earned income is scarce, so this $5 was a perfect opportunity to get started saving for retirement. She was surprised and told me she hadn’t thought of doing something like that for him at this young age, but I told her, this is the perfect time to start, because the earlier you start, the longer that money has to grow. At the end of the conversation, I asked him again, “Now that you know you won’t be able to touch that money for a long time, is your answer still the same? Do you want $5 now for the work you did, or do you want to earn $275 for the same amount of work, but you have to wait to get paid?” He said he still wanted the $275, and that made me really happy. That lesson had sunk in!
The key factor in explaining this concept to kids comes in real, solid numbers. Money is such an abstract idea, and then you tack on the idea that the money will grow. Growing money? This isn’t an apple tree, what does it mean to grow money? So you have to give them tangible examples. I’ll give you another one.
Example #2 - What does it mean to grow your money?
I was talking to a friend’s daughter, and she was asking me what I do for work. I told her I manage people’s investments so they would have enough money to live on when they stop working. She asked me what an investment was, so I told her that you can use your money to buy ownership in a company, or lots of companies. Those companies give away some of their ownership as a way to raise money. They use the money to help them grow the company, and they pay you for the use of your money. When you buy a stock, you own a little bit of that company. It’s a tiny fraction of the ownership, so it’s not like you own the company. But they pay you a fee to be able to use your money over time.
A loan is a similar example I’ll use on kids sometimes. Your parents got a loan from the bank in order to buy the house. They don’t own the whole house, and the bank doesn’t own the whole house. But the bank helped your parents buy the house by pitching in some money, and your parents pay the bank a fee, called interest, in order to use the bank’s money for a little while.
Example #3 - $3 MILLION DOLLARS?!
Here’s another example, but this one is for a slightly older child who can grasp the concept of growing money. My son is 11. We talk about saving money a lot in my house, because, well, it’s one of my passions. Especially starting to save early and teaching children to be good, diligent savers. Time is the biggest asset you have when you’re saving for retirement, and the more you can put away early, the less you end up investing overall.
So, I was sitting on the couch last week with my son. I was reading a financial planner’s blog and he was playing Minecraft. We started talking about Roths because it came up in the blog I was reading and he asked how much would be in his Roth when he retired. So I loaded a simple compounding calculator from investor.gov.
https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator
I said just for ease of math, let’s assume he didn’t put anything away until his 18th birthday, and then he got a job and started saving the maximum of $6,000 a year, and continued putting that $6,000 away every single year until he retired at age 70. He would have contributed $312,000, but that money would be worth about $2.7 million dollars. His eyes got all big and he was excited about being a millionaire for a minute. But then I said, “Ok, what if you live another 30 years, and your average living expenses are $100,000 each year. How much is that?” He said, “$3 million dollars”. So I asked him, is the money in the Roth enough? No. He would be short. So while saving $300,000 in his Roth over the course of his life was MOST of what he might need, it wasn’t enough. And that’s why in his early years of earning, when he doesn’t have a mortgage or kids to pay for, he should live simply and put away every penny he can towards his retirement, so that money can grow over a long period of time and when he starts a family, buys a house, gets a new car, and all the expensive things that come with adulting, he’ll have done the heavy lifting to set himself up for retirement. He really loved that concept that by saving early, he could make the investment do most of the work, and then he could spend money when he needed to during the more expensive portions of his life, like when his kids want to dance or play travel soccer, or go to Disney World!
Just to be clear, the money you put away for your kids must be earned by them. I employ my kids at $20 a month to do chores above and beyond the regular. It can’t be allowance, and it can’t be work any regular child would be expected to do around the house just for being a child. My kids empty the trash around the house, take the cans to the street, load and empty the dishwasher, wash the dishes, vacuum the floor if it needs it in between regular house cleanings. They’re totally on board with this, I’m not forcing them to do it. But they understand that in order to earn money to put into their Roth, they have to work more than just cleaning up their dishes and putting their clothes away.
Example #4 - Save early, then stop
It doesn’t sound like a lot, but my 6 year old started earning her salary about 18 months ago, just after her 5th birthday. So just for ease of this example, let’s use $20/month between age 5 and age 18, and then stop saving entirely for the balance of her working years. Now, in the real world, you don’t want to make a trade in the stock market for $20 unless you have 0 trading fees or you’re investing it into an ETF, which has no trade fee. So be careful what your trade fees are, or consult your financial planner when you want to get started with this. But just for easy math, we’re going to invest $20 a month every month from age 5 to age 18. That’s 13 years x 12 months, for a total of 156 payments of $20, which equals an investment of $3,120.
In order to run this calculation in the investor.org calculator, you have to use a 2 step process. The first one is to calculate monthly payments, compounded annually at 6.8%, which is the 50 year average return for the stock market adjusted for inflation, and you'll compound that for 13 years until she's 18 years old. Then you take that number, which for me was $4,818.59, and plug that in as the initial investment, with no additional payments, compounded for 52 years, until she turns 70 years old. That money, an initial investment of just $3,120 ($20 x 156), will grow to $147,000 or more without ever investing another dime.
Now this is a whole lot less than the $2.7 million my son would earn in the earlier calculation, so you definitely want to encourage them to continue to save throughout their life. But that early start is such a huge factor in lifelong savings. Not necessarily because it will save them a ton of money, but because developing those saving behaviors will lead to a saver’s mindset throughout their lives, and they’ll never have to sock away thousands of dollars at the end of their working years, and they’ll ultimately be comfortable in retirement by letting their investments do most of the work. It's important to note that Roths do have income limits, so saving early before you hit those income limits is just another good reason you can give your kids when discussing where to put their babysitting money.
Key Takeaways
The key here is to teach them as young as you can that saving now means more money later. That spending all their money right away is a backwards way of thinking. That being patient pays off big time. And that the earlier they start, the more their money will grow. Now, there are lots of other savings vehicles beyond just the Roth IRA. Over the next few weeks, we’ll discuss some other options for minors. Next week we’ll go over 529 College Savings plans, so make sure you come back for that.
If you want to learn all the nitty gritty details of a Roth for yourself, you can read all about them on Wikipedia. https://en.wikipedia.org/wiki/Roth_IRA
If you’d like a quick summary of the pros and cons, you can revisit last week’s edition where I talk about my 5 Favorite Ways to Save for Minors.
https://www.luminarywealth.com/bloglist/2021/4/5/my-5-favorite-ways-to-save-for-minors
I hope this was helpful, and if you have any follow up questions, don’t hesitate to reach out to me directly. You can email Lee@luminarywealth.com, or connect with me on LinkedIn or Facebook.
Keep saving, and have a great day!