Last Updated Nov 22, 2010 8:40 AM EST
This is a familiar subject to my regular readers. But it's such a powerful and simple device -- one that I've not seen widely mentioned -- that I want to spend a little more time with it.
The concept is simple. Every penny my college-aged kids earn in a summer job I match -- part in cash, but most in the form of a contribution to their Roth IRA. This gives them an incentive to work hard and to maximize their earning potential. It also approximates a real-world 401(k) plan, exposing them to an important life-long savings vehicle and, I hope, predisposing them to sign up for the real deal as soon as they are employed full-time.
For good reason, 401(k) plans have come under attack since the Great Recession. Despite their drawbacks, though, a 401(k) plan where an employer matches a portion of everything you save is the closest thing to a gift you'll find in the investment world. Yet some 40% of workers who are eligible for a 401(k) plan do not take part, according to the Employment Benefit Research Institute. I don't want my kids, as adults, to be part of that statistic.
Our family 401(k) does more than expose our kids to the value of these plans; it gives them a very real early start on retirement savings. I knew I was on the right track when I opened their Roth IRAs and told the financial rep what I was doing. "Wow," he said. "Don't we wish someone had done that for us when we were 20?" Indeed, we do. Here's why:
Â· An extra 10 years of saving is a game changer Say your child starts saving $150 a month at age 20 and her friend starts saving $200 a month at age 30. By the time both are 60 they'll have invested identical dollar amounts: $72,000. But your child will have $372,827; her friend will have just $235,213 (assuming modest average annual returns of 7%). That difference is entirely due to compound returns over the longer period.
Â· Saving $1 million becomes easy The first Bank of Dad contributions to my two college-aged children's Roth IRAs was $1,000 for each. That money will be invested in a low-cost mutual fund designed to match the returns of the stock market. If the kids never touch that money and retire at age 70 it will have grown to $238,637, assuming the market returns its historical average of 11% a year. If I contribute $1,000 a year for five years from ages 20 to 25 they'll have nearly $1 million at age 70. By the way, that's $1 million after-tax. The Roth IRA is a beautiful tool.
My hope is that the kids will see their money start to grow and make their own contributions when the Bank of Dad is done. Until then, though, the family 401(k) is my solution.
This approach to teaching kids about money and giving them a head start can be easily customized. You might not want to match your teen's summer earnings dollar for dollar. Okay, so match half, or 10%, or only up to a certain amount. That's more real world anyway. The key is to tie contributions to something; it shouldn't be an arbitrary amount (and by law it cannot exceed their taxable income).
One adjustment I plan to make is to start requiring that the entire Bank of Dad match -- not just most of it -- be in the form of a Roth contribution. That will really goose the long-term numbers. Do your own calculations and see how little it takes now to reach $1 million over 50 years.
For help setting up a Roth IRA for your kids, read my next post. As noted, your kids must have taxable income to have a Roth IRA; you can't do this if they are getting by solely on allowance and gifts from grandpa. Which is one more reason to encourage them to work summers or after school. Don't worry, they have time for it.
How To Set Up a Roth IRA for Your Kids
Photo courtesy Flickr user papa-t