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A Nest Egg for Your Teen

A Roth IRA for your teen could create a millionaire in the making. But how do you convince her it's a good idea? Money Magazine's Walter Updegrave has a few suggestions.

September 20 2007: 4:49 PM EDT
NEW YORK (Money) -- Question: My daughter is 16 and has earned about $2,000. I'm trying to convince her to put some or all of it into a Roth IRA. If I'm able to convince her, what investments would you recommend for her since this is money she won't touch for 40 or 50 years. - Marianne Morris, Santa Barbara, Calif.

Answer: If you can get your daughter on board with the notion of regular saving early in life, you'll dramatically increase her chances of being financially secure throughout her adult life. And although retirement is quite naturally the farthest thing from her mind, you'll also immeasurably boost the odds that she'll be able to retire in comfort when she eventually wants to.
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But before I get to what sort of investment you might want to consider for her Roth IRA, let's talk about how you might convince her to go along with your plan in the first place. I think the first thing you should try to do is to make this less of an abstract idea - saving for the future - and more about something concrete, like the actual dollars she can accumulate by socking away some or all of her earnings now.

The fact is, even if she does this for just the handful of years remaining until she becomes an adult, she can set the stage for having a truly sizeable nest egg 50 years from now. Indeed, if she plays her cards right, she could virtually assure that she'll end up a millionaire. Here are a few numbers you can share with her.

Let's say that starting this year and then for the next five years, your daughter follows your advice and invests $2,000 a year in a Roth IRA. And let's assume that she earns 8 percent a year on that money. How much money would she have in the year 2057? Well, even if she didn't save another penny, your daughter would be sitting on a pile of cash worth just under $500,000.
A gift that will help your kids grow rich

That's right, almost $500,000. And because this money is in a Roth, it would all be tax-free, assuming she meets the withdrawal criteria. Not bad for just investing $2,000 a year for six years. But let me give you another thought.

If you can convince her to put away the $2,000 this year and then for each of the next five years increase her annual Roth contribution to $5,000 (the maximum contribution for 2008), she would be sitting on a pile of tax-free dough of just over $1 million.

I'm sure I don't need to tell you that these figures are hardly guarantees. Your daughter isn't going to earn 8 percent year in and year out. But if she invests appropriately (and, don't worry, I'll get to that in a minute), I think that sums on the order I've mentioned here are definitely within her reach. (To see how much your daughter might accumulate investing different amounts or earning different rates of return, you can check out our How Fast Will My Savings Grow? calculator.)

Now, impressive as these figures are, I wouldn't be surprised if your daughter, being a teenager and all, gives you one of those withering looks that lets you know she couldn't care less about how much money she may or may not have when she's old and out of it (which, I'm sure, age 56 seems to her). And that's when I suggest you consider two other tactics.

First, you can explain to her that, while the idea is that she wouldn't touch this money until she retires, it would be a stash that she could dip into sooner if she really, really needed it for something important. Granted, withdrawing anything more than her own contributions would usually mean having to pay tax and a 10 percent penalty (although there are exceptions, such as using Roth money to buy your first home).

And, ideally, you would try to discourage her from tapping into it early (not to mention encourage her once she starts her career to set up a separate emergency-cash fund and to start saving in her 401(k) so she has other resources aside from her Roth).

Nonetheless, having this growing stash of Roth IRA money would actually give her a measure of financial independence and security even fairly early in her life. You might explain to her how liberating that can be. How nice it is not to have to be totally dependent on that next paycheck coming in. How having some money set aside gives you more options about how you live your life.
The risk of saving too much for your kids

The second tactic I'll suggest is more pragmatic. Namely, to get her to go along with your plan, you might consider starting your own "parental matching funds" program. For every dollar or two that she contributes to her Roth, you can give her another dollar to invest in it. That way, your daughter won't have to give up every cent she makes to the Roth. She'll also get some immediate satisfaction in the form of spending cash for the work she's doing.

After all, making that connection between work and pay (which is really about the ability to use our skills to improve our lives and make them more fulfilling) is just as important as planting the seed for the habit of regular saving.

If you do give your daughter money to invest in her Roth in a given year, just remember that she can't put in more than she earns for that year. So if she earns, say, $4,000 in a year, your daughter's contributions plus whatever you kick in can't exceed $4,000.

Now let's talk about how to invest however much you daughter puts in her Roth. Given that she's investing money for many years in the future, your daughter can afford to invest quite aggressively. And I'm sure many people might even say she should just go for all the gusto she can and sink every cent into stock funds.

I disagree for two reasons. First, there is always the chance that your daughter might dip into this stash before she reaches her 50s. Second, as dominating as stocks' performance has been over the past 100 or more years - and as much as I believe they'll continue to outperform in the years ahead - it's always prudent to hedge a bit.

So instead of going 100 percent stocks, I'd recommend something on the order 90 percent or so. That's plenty enough exposure to cash in on stocks if they continue to generate outsize returns. But a little bond stash will provide at least a bit of ballast during periods of market turmoil, as well as generate some returns to the portfolio during those occasional periods when stocks stagnate.

My final recommendation is to keep things simple. At this point, you're not trying to turn your daughter into an investing savant. You just want her money to grow over the long term. So you want to go with an investing strategy that doesn't require much time or effort - ideally, one that can run pretty much on autopilot.

One way to go is simply put 90 percent of her money in a total stock market index fund and the other 10 percent in a total bond market index fund. Essentially, you're getting exposure to the entire U.S. stock market and the entire U.S. bond market in two funds.

And since they're index funds, you're giving up very little of your return to annual expenses. For the names of total stock and bond market index funds you might invest in, check out the Money 70, which is MONEY Magazine's list of recommended funds.

If you go this route, you or your daughter should rebalance her portfolio every year to bring it back to its original proportions - 90 percent stocks and 10 percent bonds. This isn't complicated. Just sell off stocks if they've become a larger percentage of the portfolio, and put the proceeds into bonds. Or, if the percentages aren't that far off, just invest new money in whichever asset class has fallen below its target percentage.
Your portfolio: A rebalancing act

When your daughter is in her 40s or so, she can always shift to a less stock-intensive mix. But if you don't want to engage in even this little bit of annual maintenance, there is another alternative: Have your daughter invest in a target retirement fund.

This type of fund has a ready-made mix of stocks and bonds appropriate for one's age. That mix then gradually becomes more conservative by shifting more toward bonds over time. These funds are designed primarily for retirement investing, but I think such a fund would also work just fine for your daughter's Roth. She should invest in a target fund with the farthest possible target date available - which would be a 2050 fund - in order to get something close to a 90 percent stocks-10 percent bonds mix.

Of course, in 2050 your daughter is likely to still be working (although, who knows, if she saves diligently in addition to the Roth, she may very well retire early), so at that point the 2050 fund may be a tad too conservative for her. But, hey, that's a long time away, and she can always make an adjustment then, if but before.

For now, though, the most important thing is for you to convince her how much better off she'll be if she puts some of her earnings into a Roth, and then, assuming she agrees, help her get it invested the right way.

One final note: I also think it's a good idea for any parents out there with kids who are young adults at the beginning of their careers to encourage their kids to begin preparing for retirement early by, among other things, singing up for their 401(k) and contributing regularly to it. For more on how to do this, click here.

As parents, we tend to shower our kids with lots of material goods. That's understandable; we all want to help out our kids any way we can. But if you can help get your kids off on the right foot financially, you'll be giving them the opportunity to help themselves long after you're not around.

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