Working Teens and Roth IRAs

Summary: If you have a teenager with a job, opening a Roth IRA for them is really good idea from both a learning and a financial perspective.

Our daughter is 17 and has had a part-time job for a little over a year. She makes minimum wage and probably works about 8 hours a week on average during the school year, and a bit more during breaks if we are in town. (Ironically, this summer she’s interning at a summer camp, which means she’s working full-time but making less.) While I think it’s safe to say that not many 17-year-olds are thinking much about retirement, ours is (well, at least she is when I make her :-).

As a result, as soon as she received her first paycheck, she opened a Roth IRA via Vanguard (since she’s not yet 18, it’s a custodial account, but will become completely hers once she turns 18). Why in the world would we do that? Simple, because it’s a fantastic opportunity for her to learn about finances and planning ahead, and also because it’s an incredibly smart move financially for her to do this now.

If you aren’t familiar with Roth IRAs, they allow you to put money (earned income up to $5500 per year for those under 50) in post-tax (so you don’t get an immediate tax deduction like regular IRAs or 401ks). That money then grows tax-free (like a regular IRA or 401k) but then, and this is key, upon withdrawal is also tax free. That means for my daughter, and most teens working part-time like her, this money is never, ever taxed because she doesn’t make enough in a year right now to owe state or federal taxes.

In 2016 she earned a total of $1651 and contributed the same amount to her Roth IRA. In 2017 so far she has earned $2133 and contributed that to her Roth IRA. With some investment gains, her current balance is about $4000. She’s invested in a low-cost Vanguard Index ETF because since she started with $0 she didn’t meet the $3000 minimum for the index mutual fund, and the ETF allows you to buy individual shares at whatever the current cost is. We’ll wait until she surpasses $10,000 so that she qualifies for the low-cost admiral fund and then probably move it over into the mutual fund version (same expense ratio as the ETF, but a little less hassle on our part to invest).

So why is this an “incredibly smart move financially”? In a word (okay, two words): compound interest. If she continues to work about the same amount between now and August 2018 (she graduates in May 2018 and will probably be going to college in the fall), she will have invested somewhere around $7,500 in her Roth IRA. Including the investment gains she’s had so far and assuming a bit of a gain in the next year, let’s call it $8,000 at the point she starts college.

Now she’s likely to work part-time in college, and eventually she will begin full-time work, at which point she will most likely add a 401k to her retirement savings plan and she may or may not continue to contribute to a Roth IRA depending on the circumstances. For the moment, let’s assume she never contributed another dollar to her Roth IRA for the rest of her life, let’s explore what happens.

Well, predictions are just that, predictions, but we can do some decent estimates based on historical results. The stock market has typically returned over 10% a year on average for a long time (and small-cap value, what our daughter is invested in, is even a bit higher), but most folks think that at least in the short term (the next 10 years or so), those returns will be muted a bit. So for demonstration purposes, we’ll use 8% returns (feel free to substitute in a lower or higher amount if you want). So if she has $8,000 invested in her Roth IRA at age 18, doesn’t invest another dollar for the the rest of her life, and “retires” (whatever that will mean at that point) at age 68, how much money will she have? Over $375,000.

That’s fantastic, considering it’s totally tax free and it came simply from the part-time jobs she worked while in high school. But it also overstates it a bit, as those are not today’s dollars, but 2068 dollars, which means you have to take into account inflation. We’ll assume inflation of 3%. Historically inflation has averaged 3.5%, but it’s been lower lately, and governments try harder now to manage that rate, so lots of folks think it will be lower going forward (that’s also part of the reason that the expectation is that stocks will earn lower than 10% going forward as well). So, in reality, what we’re calculating here is a 5% real return after inflation (8% nominal return minus 3% inflation). That amounts to over $91,000 in today’s dollars. That may not sound quite as impressive, but keep in mind that’s assuming no additional investments after she graduates from high school, and that money is completely tax free. (That’s also likely more than a lot of the adults reading this post currently have saved in their retirement account.)

This entire scenario assumes, of course, that the teen can afford to invest this money. Many teens have to work to help support their family day-to-day, so this unfortunately isn’t an option for them. Ours doesn’t have to help support the family, so this is another advantage of us being financially secure – we can not only help our daughter learn about saving, investing, financial planning and retirement planning, but we can give her a head-start on her savings and investing. If your family is in a similar position, I highly recommend you consider this option and, if you choose to work with me, this is something we will investigate.

Update March 2022: Just thought I’d come back and post an update. Even with the recent swoon in the market, her Roth has now (just barely) reached six figures. She’s 22. Now, this is much more than we would have expected at this point, but due to consistent investing, amazing market returns (until the last two months), and a little bit of luck (always helpful), it’s happened. For now, I’ll spare you the updated “even if she never invests another dollar in her Roth IRA it will grow to” amount but, suffice it to say, it is rather large.

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