What's the best way to make sure your kids won't have to worry about money when they get older? Sure, you could save and save, hoping to leave them a nice windfall once you're gone. However, I believe that a better approach is to give them the tools to control their own financial destiny.
You can do so by helping them get set up in a Roth IRA as soon as they have their first job so they can enjoy a lifetime of tax-free compounding. You might be amazed at how much a little bit now could mean when they're older.
IRAs, and why a Roth IRA is the best choice for a teenager
There are two main types of IRA accounts -- traditional and Roth. Both are good options to help save for retirement.
Both types of IRA accounts have some common characteristics. For example, both accounts allow for contributions of up to $5,500 for the 2015 tax year ($6,500 if you're over 50). So your child needs some income to be eligible. Also, both account types allow your investments to grow without having to pay taxes on gains and dividends each year.
The main difference has to do with how contributions are taxed. In a traditional IRA, your contributions may be tax-deductible now, but when you eventually retire and start withdrawing your money, your withdrawals will be treated as income and subject to taxes. In a Roth IRA, you can't deduct your current contributions, but your qualified withdrawals will be tax-free.
So why do I suggest a Roth IRA for young people? Two reasons. First of all, unlike with a traditional IRA, you're free to withdraw your contributions (but not your investment gains) at any time without penalty. So if they need the money to pay for college expenses or encounter a financial emergency, their money isn't tied up and they won't be faced with costly penalties.
And most importantly, the tax benefit of a Roth IRA usually makes it a no-brainer for young people. Generally, teenagers and young adults have very little taxable income, if any. So even though you have to pay tax on Roth IRA contributions, it's usually not much for young people, and in some cases it could be nothing at all. On the other hand, once they retire, who knows what tax bracket they'll be in? By contributing to a Roth IRA, you're locking in their current, low tax rates.
How to get them interested and keep them interested
Now, I completely understand that investing for retirement may not be the most exciting topic for a 15-year-old. So it's up to you to make it seem like a worthwhile pursuit.
One effective way to get young people interested is to make it a family activity. Use stocks that are interesting to teenagers (Apple, Facebook, and Amazon.com are a few good examples) because it helps if they understand and care about what they're investing in. Then spend some time every so often reviewing their investments and tracking their progress.
Another good idea is to figure out a way add incentives. For example, you could tell them that you'll match every dollar they put in, or that if they contribute a certain amount, you'll pay for something they want (senior trip, a car when they get their license, and so on).
Of course, you can always make contributions in their name. As long as the contributions don't exceed their income, you are allowed to contribute on their behalf. So a Roth IRA can simply be a nice way to save for your child's future without having to worry about future tax issues.
Compound returns could make them rich if they start now
Why start so early? Simply put, the most powerful tool in investing is time, and your kids sure have a lot of it to work with. Just as an example, if you contribute $5,000 per year to an IRA starting when you're 30, it could grow into almost $745,000 by the time you turn 65, assuming 7% annual investment gains.
That's certainly a lot of money, but if you get your son or daughter started at age 20, he or she can build a nest egg of more than $1.5 million by 65. Or your child could potentially have enough to retire early, if that's what he or she decides to do.
For a final thought, consider that every $100 that a 16-year-old puts into an IRA could be worth $2,800 by the time he or she retires, even with a conservative return assumption. That's why getting your kids started early is one of the best financial gifts you can give.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Apple, and Facebook. The Motley Fool owns shares of Amazon.com, Apple, and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.