Who wants to be a millionaire? Your final answer might be your kid, if he or she is an ambitious sixth-grader who opens an IRA. Here’s how it works.
Who wants to be a millionaire?
If one or more of your kids has a paper route, baby-sits, mows yards or does any kind of chores for you that could generate documentable earned income, they have an investment opportunity they don’t need a lifeline to find out about. By putting the money they earn in a tax-deferred IRA – either a Traditional IRA or a new Roth IRA – your kids could be millionaires by the time they reach retirement age. And all without answering even one question for Regis.
The best part is that their original investment will be just over $9,000. Here’s the math:
At age 11, you open up an IRA account on their behalf and your child puts $250 in that year. The next year the child contributes $500, the following year $750, and so on, increasing the contribution by $250 per year until age 18. Then assume that the child never makes another contribution after the age of 18. If the money in the IRA earns 10 percent per year (a hypothetical return), the account could reach just over $1 million by age 65, assuming there are no withdrawals along the way.
If this scenario doesn’t impress you, consider what happens to a more typical IRA investor. This one begins saving at age 26 and puts $2,000 a year into an IRA for forty years, again earning 10 percent per year (a hypothetical return) and making no withdrawals. Even after contributing $80,000 over four decades, this investor may only end up with about $885,000, about $125,000 less than that 11-year-old who contributed less than one-tenth as much.
The power of compounding
That’s the power of tax-deferred compounding in action. Because money in an IRA is not subject to current income taxes, the money has the opportunity to accumulate faster than it would in an ordinary taxable account earning the same return. This example also illustrates why it’s critical to begin saving for retirement as early as possible. Even if your child is more than 11 years old, the best time to start saving is now, and the amount to save is as much as you can afford, and they can earn.
But is it Legal? Do I Have to File a Tax Return?
It’s legal for an 11-year-old to open and contribute to an IRA. Anyone under the age of 70-1/2 with earned income can contribute up to $2,000 or 100 percent of earned income, whichever is less.
And your kids can choose between a Traditional IRA, which will probably be tax-deductible in their case, and the Roth IRA, which offers tax-free withdrawals, subject to certain restrictions.
There are some financial planners that caution about what can actually count as “earned income.” A paper route or babysitting certainly qualifies. But does making your bed? If you have any questions about gray areas, such as household chores, please consult your tax advisor.
Tax consultants are split on whether or not you need to file a tax return. Some think that it’s an easy thing to do and it establishes that the money is earned income. Others say, why bother? Legally, you do not need to file a return as long as the child has earned less than $4,300. If they have a combination of unearned income and earned income (i.e. dividends, capital gains, or interest) – please see a tax consultant, but because there are some special rules that might apply.
How to get your children to save
Of course there’s a potential problem with our story about the hypothetical 11-year-old. You can pretty much assume that the chance of getting someone that young to take the money he or she has earned and put it into an IRA is close to impossible. But there’s a way to deal with that too. Just promise your kids that you’ll match every dollar they put in the IRA. That way, the child’s earned income is free to go into the IRA, and, thanks to your generosity, they aren’t short any spending money.
How much could your kids accumulate if they continue to contribute after reaching age 18? If they continue contributing, putting in $2,000 per year from age 14 until age 65, and continue to earn 10 percent annually (a hypothetical return) with no withdrawals, they could potentially have $2.75 million at retirement, from a lifetime investment of just over $100,000. Can this really be done? It can. And that’s our final answer.
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