As Austin Fey writes in The Benefits of Saving and Investing Early, “Any money you put away and invest [when you’re young] will have the longest time to grow, due to the magic (or actually, the mathematics) of compound interest.” She provides a beautiful chart and graph which accurately show just how that magic works to make small contributions when you’re young to outgrow larger contributions over a longer period of time when you’re older. If you need convincing, hop over to her article now and then come back and keep reading.
Because of this compound interest magic, someone has to be proactive about your child’s retirement. Every year you don’t open a retirement account or your child avoids employment is another year you’re holding back compound interest.
Prerequisite: Earned Income
First off, in order to fund a Roth your child has to have earned income. That earned income could be babysitting money, full time employment, or helping the family business. So long as it is earned income it qualifies.
If your child doesn’t have earned income yet, encourage them in their entrepreneurial endeavors. I funded my Roth IRA as a child by stuffing envelopes for my parent’s businesses, babysitting for my parent’s friends, and shoveling my neighbor’s driveways after big snow falls. My contributions were only in the hundreds some years, but even $100 when let loose to compound interest for 55 years can become big money.
If your child is in high school or college, still encourage them in their entrepreneurial endeavors! Send them Austin’s post or this post and tell them how much they can earn if they just start earning and saving now. My college job was one of the best college jobs in the world: being a nightly walking companion to a retired English professor. No need to only go the food services route; be creative. College newspapers are constantly advertising job opportunities, university Psychology studies frequently pay participants $5 per 30 minutes, and part-time administrative positions are constantly available in school settings.
Opening the Account
My co-worker Austin has researched all the brokerage accounts and determined that Vanguard is the best company for a self-directed brokerage account. She found Vanguard was the most favorable because they have no minimum to open an account and if you buy Vanguard ETFs there are no transaction costs and there are low costs for Vanguard mutual funds. Her analysis can be found here, if you are interested.
If your child is a minor, opening an account is as simple as filling out their online form yourself. You’ll be the custodian of the account until your child turns 18. If your child is an adult, then they will have to be involved in the process of opening an account. The process can be undertaken online at Vanguard.com at any time or over the phone (800-319-4254) during business hours. My co-worker (Austin) wrote another article which steps you through the process of setting up a Roth at Vanguard through the online process. You can find that article here.
If your child is a minor, keep a detailed record of how much money your child has earned. Create a folder or notebook where you record the date of employment, amount paid, and the job. For example, “12/19/2013 Snow Shoveling for Jane Smith, $20 cash.” If there is further proof of employment like an e-mail where you set up the babysitting job, it can’t hurt to put that in the folder in case the IRS has questions. At the end of each year, tally up how much money they’ve earned. That amount (or the contribution limit, which ever is lower) is how much you can contribute to their IRA.
If your child is an adult, you can still keep track of how much money your child has earned or you can empower them to be grown up and do it themselves. Older kids’ wages are often easier to track. Saving pay stubs is normally sufficient to know how much you’re earned. There is a greater chance too that they will get to fund the full $5,500 limit (for 2014).
Contributing to the Roth is easy. Although your child ‘s earned money limits how much you can contribute, those very dollars do not have to be the ones that go into the Roth. If your child earns $1,000, you can contribute $1,000 of your dollars into the Roth, matching their earnings in donated contributions.
You have a few options for method of contributing. You can call Vanguard for a complete list of your particular options, but here are two commons ones:
1. You can get Vanguard to create a link between the Roth account and a bank account. Once that link is established, you or your child will be able to fund his or her Roth either automatically according to provided instructions or via a simple online process. This is a particularly good option if your child is an adult with a steady full time job. You can link the Roth to your child’s bank account and set up a small automatic contribution to occur slightly after pay day.
2. Alternatively, you can make out a check to the account, making it out to the title and number of the account (ex. Betty Bopp Vanguard Roth IRA 1234-5678). Under the memo, it is best practice to put something like “Roth 2014 Contribution” to denote the intention of the check.
Now that you have contributed to the account, the question is which investment vehicle should you purchase? For anyone under 35 with a Roth account at Vanguard with small amounts of money, we would invest in the Vanguard STAR Fund (VGSTX). The STAR Fund is Vanguard’s diversified “one fund option.” It has a minimum initial investment of $1,000, but after that initial purchase you can make or automate later smaller purchases. If you choose not to automate later purchases, you should pick a day (the child’s birthday is a good option) and resolve to invest any cash back into the STAR fund.
For a more complete analysis of the STAR Fund, see David Marotta’s post “What Is The One Fund Should I Invest In?”
If you end up with a large amount of money in retirement accounts and would like to diversify further, I would recommend reading David John Marotta’s “Gone Fishing Portfolio” series. It is a asset allocation intended to be invested in and then rebalanced one a year. Here is 2014’s portfolio and the corresponding calculator. Note that the calculator only works for Portfolio values of $100,000 or higher.
If you are young and earning money, there is no excuse. Fund your retirement! The easiest time to save is while you’re young and living with your parents. Every year you wait is making it harder for you to prepare.
And parents, give a wonderful gift to your kids. Fan the flame of their entrepreneurial spirit. Get them working and get them saving! As a child whose parents did that for her, I can say it is one of the best gifts they could give me.