While many of us talk about taking an early retirement, we rarely contemplate the idea of making one for someone else. In particular, how about making one (or at least starting one) for a young family member or friend—yes, even someone as young as a teenager?
It’s graduation season, meaning teens nationwide are about to start summer jobs. I’m sure most of them have already planned how they will spend their earnings—and I’m not here to fault them for that—but that doesn’t mean you can’t be thinking about your teen’s retirement.
I write about this topic every year because I’ve seen the benefits firsthand. My parents funded a Roth IRA on my behalf during my teenage years—thank you! My mentor, who also wrote about the strategy, funded IRAs for his children when they were teenagers, as well.
Helping a young person prepare for retirement may not get you many high-fives or fist-bumps today. But trust me, the beneficiary of your forward thinking will thank you for years to come as they move into and through adulthood.
How a Teen IRA Works
It’s pretty simple. Once someone starts earning income, they are eligible to contribute to a retirement account. Even if that earner is a teenager working part-time or picking up a summer job, they can start building a retirement nest egg.
However, you do have to report the income to the IRS for it to count. If your neighbor is paying your teenager cash babysitting now and again and you aren’t reporting those earnings, you can’t contribute to a Roth IRA on behalf of your child.
A young person (anyone under 50, according to the IRS) can contribute earnings of as much as $7,000 to a Roth IRA. Make just $3,000 working this summer, and they can put $3,000 into a Roth IRA. Earn $10,000 working part-time, year-round, and their contribution is capped at $7,000.
Do I really expect a teenager to save for retirement? No, but that doesn’t mean we “elders” can’t help them!
Let’s assume you can afford to match your teen’s summer earnings. Do it. Let them have their hard-earned money, but open a Roth IRA in your child's or grandchild’s name and add the money yourself. (Though it doesn’t have to be a family member. You can do this for any teen you want to help out.)
Maybe you can’t afford to add the whole amount. Consider making a deal with your teen to match a portion of any earnings they add to the Roth IRA. If the teen contributes $250, maybe you’ll contribute $500 or $1,000. I’ll show you in a moment how even small contributions add up over decades.
Roth over Traditional
I was intentional when I wrote “Roth IRA” in the paragraphs above because they are a better choice for younger people than traditional IRAs.
Traditional and Roth IRAs are powerful options that allow you to compound your earnings tax-free. But, of course, you have to have a long-term mindset. The money contributed is generally locked up until the IRA’s beneficiary is 59 ½ years old—unless they feel like paying a 10% fee on withdrawals.
There are some exceptions to that penalty—for instance, if the distributions are used for a first-time home purchase (something today’s kid might appreciate down the road) or to help with a disability—but really, you shouldn’t expect this money to be touched for years and years. Once clear of the age of 59½, that 10% penalty disappears.
But Roth IRAs have the clear advantage over traditional IRAs—though, again, your teen won’t understand why until they are well down the retirement road. The advantage is withdrawals.
A traditional IRA forces you to take distributions in retirement (for today's teens, that means the age of 75), paying income taxes at your future, and possibly higher, tax rate. With a Roth IRA, once you hit retirement, there is no distribution requirement—if you don’t feel like taking money out or don’t need it, you can leave it to continue growing tax-deferred. And if you do make withdrawals, they are entirely tax-free.
Also, it’s worth noting that the owner of a Roth IRA can withdraw contributions at any time, tax- and penalty-free, after five years. Since taxes have already been paid on the contributions, they won’t be taxed again. It’s the earnings that would be taxed and subject to a penalty if an early (pre-59½) distribution is taken.
To be clear, I’d strongly discourage anyone from doing this—the ability to compound tax-free for years is so powerful. But the option is there.
The bottom line is that putting money in a Roth IRA where a teen can leave it to compound tax-free indefinitely and avoid paying taxes on withdrawals in retirement is a gift they will come to appreciate greatly.
Spending Decades in the Market
The power of compounding makes funding a teen’s Roth IRA an intelligent investment.
I’ve written several articles—like Compounding Takes Time and Put Time on Your Side—demonstrating the benefits of saving and investing early. It takes patience and discipline, but compounding works over time. (Feel free to share this and either of those articles with any young person you are encouraging to start investing.)
But let me show you the value of helping a teen get an early start on funding their retirement—even if you can only help a little for a limited time.
Let’s say your teen starts their first summer job at age 15 and continues to hold it through college (age 22). You can contribute $1,000 to their Roth IRA each year for those seven years, for a total of $7,000.
Would it be worth it if another penny was never added to the account? Absolutely.
Consider the chart below, where I’ve plotted the growth of our teen’s portfolio over time, assuming different rates of return.
Even if your teen’s money goes on to only compound at a 6% annual rate, they’ll turn that $7,000 into over $80,000 by the time they turn 60 (and can start withdrawing it penalty-free). If they leave the money untouched and it continues to grow 6% per year for another decade, they’ll have around $145,000 in the account on their 70th birthday. Not too shabby.
The results are even more compelling if your teen earns better returns. Stocks have historically compounded around 10% per year. Compound at 10% a year, and that $7,000 contribution becomes nearly $400,000 on your no-longer-a-teen’s 60th birthday. Give it another ten years, and we’re looking at a portfolio worth a million dollars.
Of course, stocks don’t go up in a straight line, so in the chart above, I’ve included the actual results of an investment made in 500 Index (VFINX) starting with the index fund’s first full calendar year (1977). Again, only $1,000 was contributed in each of the first seven years.
We don’t have enough history to get to age 70 in this example, but as you can see, the actual returns of 500 Index are tracking above the smooth 10% annual return scenario. That’s no surprise, as 500 Index compounded at an 11.2% annual rate between 1977 and 2023.
Even if you can’t contribute the full annual amount ($7,000) and don’t know if your young adult will follow your lead, doing what you can today is worth it. As long as the money is left in the account and allowed to grow tax-free, compounding can turn a little into quite a lot if given decades to work.
What to Buy
When initially funding your teen’s Roth IRA, you may have to contend with the fact that most Vanguard mutual funds require a $3,000 investment to get in the door.
To bypass this investment hurdle, you can buy an ETF—the minimum amount you need is the price of one share. Since we’re talking about a young investor with years and years ahead of them, go with a stock ETF.
You can’t go wrong picking S&P 500 ETF (VOO), Total Stock Market ETF (VTI), Total International Stock ETF (VXUS) or Total World Stock ETF (VT)—or mix and match as you see fit.
Amongst Vanguard’s mutual funds, your low-minimum ($1,000) options are STAR (VGSTX) or the Target Retirement funds. They are better than leaving the money in cash, but a significant drawback of these options is that they invest a portion of the assets in bonds. Your teen’s retirement is decades away, so they shouldn’t hold bonds in this account.
If you’re willing to open an account outside of Vanguard, another idea is to go directly to one of the PRIMECAP Odyssey funds, where the IRA minimums are also just $1,000. You can find them at www.odysseyfunds.com. (POAGX, as long as it’s open, would be my pick.)
Also, if your teen is interested in the markets, this is a perfect place and time to let them call a few of the shots. Do they have a favorite brand? Maybe they want to buy some stock in the company.
Of course, as the account grows, you (or your teen) will want to consider a portfolio that isn’t constrained to “low-minimum” funds.
All Aboard
Time is on a kid’s side, and by helping one start to build an IRA with earnings from summer and part-time jobs, you may be able to make a meaningful impression on them. Not only are you booking them an early seat aboard the retirement train, but you are also helping them develop lifelong habits (of saving and investing) that will stand them in good stead as they pass into and through their working years.
So, mark your calendar now—next March and April, tote up what Mr. or Ms. Gen Z earned in 2024 and fund that IRA account before the April deadline.
Helping to put your teenage—or just newly employed—child or grandchild on the road to a more comfortable retirement may genuinely be one of the best gifts you can give, and it will keep on giving year after year.