It’s not just Warren Buffett who believes that the power of compounding is one of the most essential tools for long-term investment success. The concept of compounding is often introduced in the context of a twenty-something’s first professional role or perhaps when establishing a 529 plan for a newborn child. But families often overlook opportunities to help their children leverage the power of compounding in their early years.
Earned Income = Opportunity to Compound
So long as a child has earned income – most easily evidenced through a W-2 but not necessary for these purposes – they can contribute to an IRA or a Roth IRA, that year. The contribution is limited to the lesser of (i) the child’s total earned income that year and (ii) the annual limit set by the IRS (which is $7,000 in 2024), and there is no age limit as to who can fund an IRA. Importantly, either you or your child can actually fund the IRA account that year. You can decide to have your child spend their earnings (rather than invest in their IRA account) if you choose to use part of your annual gift exclusion for this purpose ($18,000 in 2024).
Whether it be a summer job during high school/college or their first job babysitting or refereeing local sports games, your child has the opportunity to start the compounding clock early in life…and the impact can be massive. Let’s look at a simple example. Say your child invests $1,000 in earnings in an IRA when they are 15 and then an incremental savings of $2,000, $3,000, and $4,000 over the next 3 years. Let’s say they then save $6,000 per year once they turn 19 years old (~freshmen year in college) through their 25th birthday. If these invested dollars – $52,000 in total – earn 7% per year compounded, your child would have more than $1 million in their IRA account when they reach the age of 65!
Not Just Compounding, But Tax-Free Compounding
Since your child will likely have low earnings at these stages in life, their income tax rates will be low or even zero. This quite likely makes contributing to a Roth IRA a prudent move. Assuming so, the $1 million+ that we allude to in the example above could accumulate in your child’s account would be able to be withdrawn tax-free. Further still, given that Roth IRAs are not subject to required minimum distributions (i.e. you can control when and how you use the funds in these accounts after age 59 1/2), your child will have significant flexibility in planning for and using these monies.
Helping parents teach their children important financial lessons is one of the most enjoyable parts of what we do. Effectively leveraging money earned in their earliest jobs can not only teach them one of the most powerful financial lessons, the power of compound growth, but can also help them build significant value in the process.
