Yes, we know! A FI topic with such a bold statement – a Roth IRA for your Kid will make them a millionaire! And we bet that you’ve not found a solid resource outside of ChooseFI regarding this “secret,” but we’ve covered this topic extensively in our podcasts and in other blog posts.
We want to give you more value by introducing Child psychology as it relates to FI. Combining the two is incredibly natural for several reasons: To show the pay-off of opening a Roth IRA for your Kid and the important psychology behind it. We also want to show how this natural combination pays tangible and intangible dividends (yes, pun intended). And finally, how you can teach your child important FI lessons and make your kid a millionaire by the time they retire!
Still thinking click-bait? Get out your wallet for a wager…
Ah! You ARE on the path to FI – we already see you putting it away! So now that we know you are eager to find out the “how” and “why” let’s get right into it!
- Why Plan for Retirement at Such a Young Age?
- The Roth IRA for Kids Stipulation
- Compounding Returns: Starting Early Makes the Difference
- Psychology of Teaching Your Kid Early About Investing
- The Bottom Line
Why Plan for Retirement at Such a Young Age?
That is a great question! Not many people even start thinking about retirement until their early 30s! Starting a Roth IRA for your child may sound unconventional, but it’s the single best decision you can make for their future. Why? Let’s review a few things regarding a Roth IRA for Kids and its benefits:
- Roth IRAs (IRA: Individual Retirement Account) allow you to contribute post-tax dollars from earned income into an investment portfolio.
- There is no minimum age or balance requirement to open a Roth IRA.
- You are allowed to invest up to $6,000 per year or your child’s maximum earnable income (whichever is less).
- Contributions do not have to be made by your child, but must not exceed $6,000 per year or their maximum income. This gives you great flexibility in how to fund your child’s account.
- Funds invested, including the returns it accumulates, grow tax-free and can be withdrawn tax-free at age 59 ½.
- Your returns are compounded, meaning you earn returns upon returns. In straightforward terms, you earn returns on your contributions and the returns it earns – the crux of why you should open early.
- Roth IRAs also offer flexibility in withdrawals prior to retirement. For instance, your child can withdraw $10,000 towards the purchase of their first home penalty-free (including early withdrawal penalties and tax penalties). This is one of the reasons why a Roth IRA for Kids is a rare beast.
Why a Roth IRA?
Why a Roth IRA for Kids and not a Traditional IRA for Kids? Simple: Traditional IRAs are funded with pre-tax dollars, whereas Roth IRAs are funded by post-tax funds.
- Considering that your child’s income tax liability will be incredibly low, a Traditional IRA has no tax upside when contributing.
- With a Traditional IRA, your child will have to pay income taxes on any withdrawals during retirement. As you can see above Roth IRAs behave inversely.
OK, we’ve shown you the nuts and bolts. Let’s look at the goals of our message to you on why you should open a Roth IRA for your child as soon as possible.
Compounding returns are the primary reason you should open a Roth IRA for your child. Returns are compounded each day you have funds invested, making a portfolio grow exponentially (if you invest early enough, which we are). Combine our perfect timing with a relatively modest contribution each year, your child can be a millionaire by the time they retire. See? Not click-bait. We’ll prove it in our first example further on.
Think that saving instead of investing is a better idea? It isn’t. Standard savings accounts, like we were raised on to be our financial haven, are now a waste of time. “Premium” savings account yields are 1.5% a year. This is the upside. Inflation is clocked in at 3% per year. Roth IRAs are both a tax and an inflation destroyer.
Keep in mind that the path to FI is always about the long run. Most basic accounts, like savings accounts, are simple returns. You need compounding returns in order to make your money work the hardest for you. This is not a hit-and-run financial opportunity. Patience and discipline will make this pay off in ways you’ve never imagined.
The earlier you teach your children the importance of FI the better. You can set this example by visually showing your child their portfolio balance and how it grows. This creates habit-forming behavior by continually contributing and proving financial growth over time.
Your child will learn to feel secure about the importance of FI and will get on the FI path earlier in life. This is invaluable. How many of us, even those in our late teens, wish we started our path earlier? Wish we had the direction to obtain the tools and support to FI earlier? All of us do.
We’ll include some more examples in a little while, but let’s tell the tale of how this exactly works for your child. And, as always, there is a monster lurking in each great story. Don’t worry – he’s tiny and we’ll tackle him first, so don’t go running under the bed just yet.
The Roth IRA for Kids Stipulation
As with most great opportunities in life, there is always a catch: your child must have earned income, which is defined as compensation received from labor. There are also specific tax implications that come along with this, as you typically don’t file taxes for a child. Let’s take a look at these concepts.
Here are some guidelines set forth by the IRS about how they define earnable income for children under 13:
- Allowances do not count towards earned income (e.g. making your bed); however, if it can be established that you could hire someone to perform reasonable duties (e.g. cleaning the house, mowing the lawn) they can be classified as earned income.
- As your child gets older and can work outside the home, they are allowed to perform the following duties:
- Delivering newspapers
- Moving lawns for other families
- An actor/model (we all did this to get hired for ChooseFI)
- Work for a parental owned business
When your child reaches the age of 14, they may work under certain conditions with public and private companies (which puts them under the standard tax code).
Tax Filing Requirements for Kids: Here Is the Rub
Tax laws differ from state to state, so please check your local state tax codes for qualifications and potential tax implications. Here is a helpful link to give you an overall idea: Tax Filing Requirements for Children
We strongly suggest that you check with your accountant and/or brokerage firm for more details regarding tax reporting and filing. As each state tax code differs there can be no “blanket” approach. This is the only “catch” that we have in getting started with your child’s Roth IRA. Trust that this obstacle is a small one. We’re about to show you.
Compounding Returns: Starting Early Makes the Difference
We’ve described compounding returns in a vacuum, but let’s dive right into the specifics. Take a look at these examples and see how big of a difference getting started early can be. We are talking about the difference between a few thousand dollars and a million dollars.
FYI: your child will now be referred to as “Johnny” – apologies for the generalization.
How Roth IRA Contributions Can Make Your Kid a Millionaire
We know, this is the big one:
Johnny starts mowing lawns at age 9. The first year he makes $4,000 – yes, he’s been busy! You decide with Johnny that putting $3,000 into a Roth is the best decision for his future. You can approach this situation one of two ways:
- Johnny can contribute all of the wages himself – leaving him with $1,000 to spend for the year.
- You can make an agreement with Johnny that you as the parent will contribute “X” amount ($1,000, $2000, $2,500) and that Johnny will make up the difference (“Y”). We’ll cover more about this in the psychology section.
If Johnny were to put $3,000 in his Roth IRA at age 9 and not touch it again until he was 64: he would have $123,945! But we want Johnny to be a millionaire! You probably think it would take contributions of thousands to tens of thousands of dollars per year until 64, right?
If Johnny were to add just $1,500 per year from ages 10 to 64 to his Roth IRA, he would be a millionaire: $1,048,310, to be exact! This is tax-free income!
Still Not Convinced?
If you aren’t entirely sold on the impact compounding returns make in this example, let’s use a more relatable one:
You start saving for retirement at 31 – the average “start age” for American citizens. You max out your Roth IRA contributions at $6,000 per year. This includes contributions every year, from age 31 to age 64. The result? You’ll only reach $764,145.
So, if you started 20 years prior with half the contribution upfront, plus a quarter of the contribution annually, you would be ahead about $250,000. This is the very reason why you need to get started with your child’s Roth IRA as early as possible.
How Even Just One Contribution Makes an Impact
Johnny doesn’t start working until he is 14. He gets a job at a local coffee shop. His taxable income is $7,000 per year. Unfortunately, you don’t have the means to assist him in adding to his Roth IRA in a massive way; however, you are on your path to FI and want to teach him how investing can work for him.
You both come to an agreement to invest $2,000 each (a total of $4,000) for just that one year. If Johnny were to leave that money untouched in his Roth IRA until he reached age 65 (this includes no additional contributions), he would have $126,076!
Similar to the first example we gave where Johnny became a millionaire: if you, at age 31, invest a one-time $4,000 into your Roth IRA – you’d have a whopping $39,912. If you invested that same amount 17 years earlier, you would retire with triple your investment.
How Small Contributions Over Time Make an Impact
Johnny starts a paper route at age 7. He makes $300 a year. Unfortunately, Johnny isn’t willing to part with his newly earned money just yet. But, here is a good time for a lesson in the psychology of FI (which we will deep dive into soon). You open a Roth IRA for Johnny for $300. And begin showing him how investing will work for him. Yes, he’s 7, but good habits are instilled early.
So, considering Johnny’s initial contribution of $300 at age 7 and a yearly contribution of $300 until 60, he’ll net $171,721! Not only that, you’ve introduced him to a lifestyle that you know will pay even better dividends as time goes on.
Check out our awesome Roth IRA calculator to check out the results of your own potential return on investment!
The New Trust Fund
As you can tell, a Roth IRA could quickly replace your trust fund for your child. Because of its unique tax structure and compounding returns, it’s an obvious choice to make for your family as soon as humanly possible. Further, imagine the one-two financial punch of a Roth IRA and a trust fund. Your child could achieve FI with simple planning and a small relative investment.
Psychology of Teaching Your Kid Early About Investing
So, we’ve covered the mathematical and the “numbers-on-paper” reasons why a Roth IRA for Kids is a no-brainer financial choice for your child. Now, let’s take a closer look at the long-run positive psychological effects of teaching your child how to become FI as early as possible.
Teaching your children about FI is incredibly important – as you’ve seen with compounding returns. However, the benefits don’t end at a million-dollar nest egg. As we alluded to, we all wish we had started earlier with FI intensive investing. Even the best investors among us want a “do-over” button to press when we know we could have made smarter, more focused, disciplined decisions. Therefore, teaching your child the value of money and why investing is by far the best choice for their future is tantamount to raising them to follow their dreams. Because FI is not just “financial independence” but it is also “time independence.”
On the Path to FI
At any age, we understand what money is. Even a young child has a vague understanding that money equals a new candy bar or the coolest toy. But, what we all seek as those on our path to FI is independence (hence the “I” in FI). Let’s take that concept and extrapolate it to a child’s point of view.
Obviously, your child does not work for subsistence. Notwithstanding labor laws, we all want what is best for our children. “Putting them to work” is outside the boundaries of thought. However, ask any parent why they allow their child to work and they’ll usually say: “to teach them the value of money.” This is a fantastic, positive way to raise your child. Let’s augment that with the concept of independence. As difficult as it may appear (since we all do not force our children into the workforce) it is a simple addition to your already practical approach.
Time v Money Through a Child’s Eyes
Put this in perspective for your child: the idea that financial freedom will allow them to do whatever it is they seek in life. That this methodology is the way they could live a life free of worry and avoid work they do not want to do. One tool that is used in child psychology is the implementation of a reward system that uses “monopoly money” for treats. Straightforward? We have a twist: instead of receiving 1 treat today, if they invest their “money” and wait until the end of the week, they can have 10 treats instead of 7 daily. This helps adapt a child’s mindset to waiting for satisfaction instead of the immediate. They “spend” their time to receive a greater reward.
This is the economic theory of “time v money” in practice. You either spend your time or you spend your money. Had we all invested in a Roth IRA as Kids we would be unbelievably well on our way to FI. If you can teach your child the true value of money; that delaying immediate gratification can lead to a massive pay-off: you are well on your way to getting them on the path to FI.
Level Up: Trying to figure out how to teach your child to be responsible with money? Get them ready for their future by equipping them with the ability to think creatively, solve problems, make smart financial decisions, and appreciate the value of money with The Simple Startup Challenge.
Childhood Development and Parental Involvement
Child psychology often referred to as “Developmental Psychology,” is the science of human behavioral growth between birth to adulthood. Understanding the following fundamental psychological concepts will help you get a better understanding of why you should teach your child the importance of FI.
Child Development Psychology and Financial Independence
Children inherently look to their parents for direction on how to behave. This may not seem like the case if your child is young; however, psychological studies have proven that the most impactful human behavioral growth occurs between the ages of 18 months to 11 years old. Developmental psychologist and field pioneer Jean Piaget created a framework that breaks down the specific learning stages in correlation to age. Technical jargon warning (don’t worry, we’ll break it down):
- Birth to 18-24 months old: object permanence (the understanding that objects that cannot be seen still exist – example: think “peek-a-boo”).
- 2-7 years old: symbolic thought (the application of learning from other’s behavior, learned behavior, and thought-to-language fluidity).
- 7-11 years old: operational thought (logical reasoning and critical thinking skills develop).
- 11-16 years old: abstract concepts (the ability to conceptualize ideas that are not visually observed – example: your brain can be visualized; your mind can only be conceptualized).
So, let’s apply this framework (from ages 2-11) to teaching your child the importance of FI.
Even though this breakthrough occurs before the age of 2, the concept obviously carries over. Teaching your child that money is a limited resource by giving and taking it away in exchange for rewards is critical. It’s a basic building block for the next developmental step, which is the heaviest hitter for our FI approach.
This is the critical developmental stage where you become the role model for your child. Slowly involve them in money-making decisions (e.g. creating your grocery store budget – take them with, how many movies they can rent from your favorite streaming service). This will instill the necessary framework they need to understand the scarcity of money. Further, as they get older, implement a disciplined approach to spending habits. Give them visual representations of what you could purchase vs why you invested in their Roth IRA or your own investment account(s) (e.g. a poster board with a new toy pictured on one side – your child’s current Roth IRA balance on the other).
This is the stage where your child is entering early adolescence. Encourage them to perform additional duties around the house to earn an allowance. This naturally bridges into a desire for more income. It’s a form of discipline that will help shape their appreciation of money and how hard work can equal more funds. More funds equal more opportunities and freedom.
The Pay-Off to You and Your Child
With this earned income, you can open a Roth IRA for your Kid: so remember to frequently show them their current balance, encourage them to contribute to the fund, and prove to them that its growth over time will be well worth the short-term sacrifices. The earlier you begin teaching your child the tenets of FI the more successful they will be in achieving the life of their dreams. And you can rest assured that you’ve not only done everything you have in your own path to FI, but you’ve also instilled the FI virtues towards your child’s future success.
The Bottom Line
If we were to encompass our message in one word, it would be this: time.
We’ve shown you the magic of compounding returns and why opening a Roth IRA for your Kid is a no-brainer. With the proper amount of planning, you can very easily ensure your child will retire a millionaire! However, don’t be discouraged and think you’ve “missed the boat” if your child is a little older. The earlier you start the better. Just a couple of years earlier can mean a 5-figure increase in your child’s retirement.
We’ve also shown you the importance of teaching your child about the values of FI as early as possible. Not only will this grant them access to becoming a millionaire, but it will also give them the financial discipline and structure to make their own decision to seek the path to FI.
FI is freedom. FI is the gateway to a complete and happy life of your own design. We all want this for our children’s future.
So please, empower yourself with this information to give the gift of FI freedom to your children and grandchildren – and secure their financial future.
When And Why Your Child Should Open A Roth IRA
How To Fund Your Child’s Roth IRA And Other Tax Optimizations With The FI Tax Guy
How To Open A Roth IRA For Kids And Teach Your Kids About FI