Not as hard as you might think. It is possible for a child to become a millionaire, indeed a multi-millionaire, by investing in an individual retirement account (IRA) at an early age. The magic of compound interest over five decades (e.g., age 15 through age 65) is positively awesome and can turn even small regular deposits into a substantial nest egg for retirement. The only “catch” is that children, like all IRA depositors, must have earned income from a job or self-employment. Gifts and allowances don’t count.
In addition to paid employment, many children earn cash payments from activities such as lawn mowing, car washing, newspaper routes, and babysitting. Keeping a simple log of the date and payment for these activities (e.g., April 30, lawn mowing for Mrs. Smith, $25) is recommended to provide proof of earned income in the event of an audit.
So-called “Head Start IRAs” can begin as soon as a child has received any sort of income, perhaps as early as age 10 or 12. If parents own a business, opportunities to hire their children may also be available (note: be sure to pay a reasonable wage to avoid IRS scrutiny). The reality, of course, is that most children who struggle to earn $500 or $1,000 over the course of year aren’t about to lock up their hard-earned money in an IRA for 50 years. That’s O.K. Their parents or other benefactor can fund an IRA to the extent of a child’s earnings. For example, if 17-year old Susan earns $1,000 and has other plans for her money, her grandfather could put up to $1,000 in an IRA in Susan’s name.
The growth of an IRA over five decades is phenomenal. If a teen (or someone on their behalf) contributes $2,000 to an IRA for just five years from age 14 through 18 and never contributed another cent, they’d have almost $1.2 million at age 65. If an even younger child contributed $500 at age 8, $750 at age 9, $1,000 at age 10, $1,250 at age 11, $1,500 at age 12, and $1,750 at age 13, and $2,000 annually from age 14 to age 65, they would have over $4.2 million. These examples assume a 10% average annual return.
Here are two final thoughts about long-term IRA investing. First, children should almost unquestionably fund a Roth IRA. Tax deductions are of little consequence at an early age compared to the appeal of tax-free withdrawals of money that has accumulated over 50 years. Earnings from traditional IRAs, on the other hand, would be fully taxable at a child’s retirement age tax bracket.
Second, the impact of earning a higher return (e.g., 10% instead of 7%) and paying lower investment expenses over time should not be underestimated. A long time frame, attractive investment yields, and low expenses (e.g., a 0.20% expense ratio on a stock index fund) provide young investors with a priceless advantage: the potential for financial independence.
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