With summer here in the States, many students are using their free time in a variety of ways – beach trips, extra courses for school, and earning money with work.
If your teen has a job or is planning on working this season, you have a chance to help them get a head start on building their net worth. That’s because income from summer jobs can be used to open and invest in an IRA.
How IRAs Work
When people look at IRAs, they may have two options- traditional and Roth. The advantage of using an IRA as a part of your child’s retirement portfolio have to do with taxes.
- Roth IRA –As your teen contributes and manages their Roth IRA, their transactions (such as buying or selling funds) have no impact on taxes. The biggest plus is that your teen’s withdraw at retirement will usually be tax-free.
- Traditional IRA – On the other side of the equations, traditional IRAs allow your teen’s contributions to be tax-deductible. That means they’ll get benefits upfront rather than waiting for them down the road since their distributions at retirement will be taxed as income.
No matter which type of IRA you choose to start, the annual contribution limit is $5,500. For most teens, their earned income from their job will most likely not meet the maximum. That’s ok, because even a small amount goes a long way with retirement.
How Teens Can Jump Ahead with Roth IRAs
With teens, starting early gives them a huge leg up, even if they’re only contributing small amounts. How? The advantage is due to compound interest. The two most important factors for obtaining the benefit of compound interest are the rates of return and time.
- Time: The more time your teen has between when they started investing and when they’ll use that money as part of their retirement, the more that money will grow.
- Rates of Return: The higher the rate, the faster your teen’s money will grow. According to S&P data collected, the actual average return of the S&P 500 from 1928 to 2012 has been just over 11%.
To help your teen see the financial benefits of starting now versus waiting until later, you can use a spreadsheet program to create a visual chart showing how much money they can actually have.
It’s one thing to talk about finances, but it can be incredibly motivating to see $1,000,000 displayed clearly.
Make It Easy to Invest
As with most people, teens aren’t looking for complicated and cryptic investments. They want something that is easy to maintain and that can give them results. Two efficient investing options that may appeal to them are index funds or ETFs and target date funds.
Index funds and ETFs track several different sectors and markets and will invest in the entire index.
With just a bit of research you can quickly create a diversified portfolio with a minimum of fees. That will mean that more money will be directed at growing your teen’s balance rather than lining the pocket of an inefficient fund manager.
With target date funds, you have the advantage of getting a diversified portfolio that will adjust asset allocation as it gets closer to your child’s retirement date. Most target date funds are labeled by estimated date of retirement with 5 year increments.
Open an IRA for Your Teen Today
The great news is that it’s easier than ever to open an IRA for your child. With their basic information in front of you, an IRA can be opened in about 20 minutes.
Even if you start off small, you’ll be helping your teen not only develop valuable financial habits, but you’ll give them a jump start on retirement.