• Philip Stratton

Why Your Teenager Should Be Thinking About Retirement

Teens don't typically think long-term strategies. That's not surprising. They have only been alive for less than 20 years (hence the term teenager), so thinking 40 or 50 years into the future is sometimes too abstract. But if they only knew how much their future selves would benefit from a little education and effort, maybe they'd be more willing to make an investment into their own future.

Investing seems complex and confusing. Especially for young people. It isn’t really. My 17 year-old son and I have been talking about this quite a bit lately. Here's what I might tell his friends about retirement investing.

First and foremost, if you have adults telling you not to worry about retirement because you're young and have plenty of time to worry about that kind of stuff, DON'T LISTEN TO THEM!

If you earn income, you should consider putting some of that money into retirement accounts that can grow over the years through the magic of compounding so it might provide a reliable source of income during your retirement years.

What is earned income? Any job that pays you money and you claim for income tax purposes. It doesn't have to provide a W-2 for taxes, but should be documented (for example a 1099-MISC would be ideal) that you were paid income and you do need to file taxes claiming that income in order to contribute. Babysitting, odd jobs around your mom or dad's office, neighborhood lawn mowing, etc., are good examples.

How much can you put into your retirement account? Let’s focus on an IRA (Individual Retirement Account) for this discussion. You can’t contribute more than you make and the maximum limit is currently $6,000 per year ($7,000 for anyone 50 or older who happens to read this).

When should I start a retirement account? As soon as possible! As the saying goes, “time in the market beats timing the market”.

Is there a minimum age to open an IRA? No, but your parent/guardian must open a custodial account for you until you which becomes yours when you turn 18.

How do I (we) open an IRA? Financial advisors can be found at banks, brokerage firms, insurance companies, etc. But the best way in my opinion is to open an account with a low cost brokerage such as Vanguard, Fidelity, or Charles Schwab. These companies allow you to have investment accounts that have extremely low (some are even ZERO) administrative fees and do not charge commission (referred to as “no load”). Just complete the application and voilá, you’ve opened an account.

What is this traditional versus Roth stuff? A traditional IRA was the OG of IRAs. Think of it as “don’t tax my income now, tax it when I retire”. Whatever money you contribute is reduced from your taxable wages when filing income taxes for that year. But, when you withdraw that money after you retire, the money you withdraw is taxed as income for that year. So, all the growth your investments generated is taxable money. A Roth IRA is the new kid on the block. Named after the Senator that sponsored the bill that created the rules (William Roth), this can be thought of as “tax me now instead of when I retire”. When contributing to a Roth, you don’t reduce your taxable wages when you prepare your income taxes. But since you’ve paid your income taxes already, all the growth your investments generate throughout the years is not taxable when you withdraw it. There are several benefits to this strategy. Let's say you ran a business that made butter, cheese, cakes, and ice cream. Would you rather get your milk and eggs tax-free but pay tax when you sell the products you made at a much higher price, or pay the tax on the purchase of milk and eggs but be able to sell your products and not pay tax on the profit? Usually the most benefit would be achieved by not paying tax on the profit received from the sale of your products.

OK, I opened my account and chose the Roth option. Am I ready to start putting money in?

Not quite yet. Think of your IRA as a container of sorts, let’s imagine a refrigerator. The refrigerator is your Roth IRA. It will hold your assets. When you opened the IRA, the brokerage established a managing account. Usually this is a money market account. It might be called your “core account “ and functions like an interest bearing checking account. When you put money into your IRA, it first goes into that account. Your money is still very “liquid” at this point. You could leave money there or from this account, you can invest it into the various products your brokerage offers. You could buy products like stocks, bonds, and real estate investment trusts (REITs). If you pick the right ones, they could make you some money, but they could also go bad very quickly. A good strategy, especially when you're young, is to buy shares of well diversified stock mutual funds. There are A LOT to choose from. An index mutual fund matches the gains/losses of certain groups of stocks like the Dow Jones Industrial Average of the top 30 companies or the Standard & Poor’s index of the top 500 companies. There are indexes that track only the very large corporations (Large Cap), mid-size corporations (Mid Cap), and smaller corporations (Small Cap). The favorite of many investors, especially younger investors that will have many years of investment growth ahead of them, is the Total Stock Market Index Fund which represents an investment in all 2,800'ish corporations traded on the New York Stock Exchange. This fund tracks the ups and downs of the ENTIRE stock market. Target date funds are another popular option since they automatically adjust the stock-bond distribution ratio as you get older in order to reduce market fluctuation risk in your retirement years. So you have to decide which fund, or funds, you wish to invest in. Then once you contribute money into the IRA (via the money market/core account), you purchase the investment instrument from there. You can easily setup an automatic transaction that instructs the brokerage to purchase the same investment instrument(s), for example the Total Stock Market Index Fund, whenever money is deposited into the money market/core account. The simpler you make it, the better.

How much should I put in? Ideally $6,000 per year ($500 per month), but let's start with whatever you can afford! The goal is to create a habit of putting in some money from each paycheck even if only $10 or $20 for now. Consider this: if you contribute $150 per month ($1,800/year) into an index fund that returns 9% per year on average from age 18-26 (9 years, $16,200 total) and then stop contributing, by time you reach 67 years old you’d likely have over $1.3M available for retirement. On the other hand, if you wait until you’re 27 and contribute the same $150 each month until you turn 67 (40 years, $72,000 total), you’ll only have $703,000 in your retirement account. That's the power of compounding! Recall from earlier - "time in the market beats timing the market". This statement means having your money in the market longer is better than trying to find ways to get a higher rate of return than the market average.

What is the market average? Historically, the total market has averaged between 9-10% over very long (30+ year) periods. Using 9% to calculate your returns for retirement investments is a conservative approach.

But why is the difference so drastic? There is a principle called the "Rule of 72". Divide 72 by the interest rate you expect to receive from your investment and the result is the number of years it will take your money to double. 72/9% = 8 years. 72/10% = approximately 7 years. 72/.25% (bank savings accounts) = 288 years. So, starting so young provides an opportunity for the money invested early to double more times than the money invested later, even when more contributions are actually invested!

When will I have enough money to retire? That's up to you and your choices. It depends on how much debt you allow yourself to accumulate, the lifestyle choices you become accustomed to, and what you choose to value. Take a look at how others live and what they spend in order to maintain their lifestyle. Is $50k per year enough? Is $100k per year more realistic? Whatever number you come up with, multiply that times 25. Let's assume a pension and Social Security payments are not guaranteed. This number becomes your target retirement amount. $50k x 25 = $1,250,000. $100k x 25 = $2,500,000. Looking back to the example from earlier, the person who invested only $150 per month from age 18-26 would have enough money to retire on an investment income of $50k per year!

Why use a factor of 25? Based on what's known as the Trinity Study, one can safely withdraw 4% of their portfolio each year with virtually no risk of depleting their retirement investments during their retirement years. Multiplying your annual expense estimate by 25 is the reciprocal of finding 4% of your total savings. $50,000 x 25 = $1,250,000 and $1,250,000 x 4% = $50,000. This is known as the 4% Rule.

I imagine this information might lead to many questions, which is a good thing. There are other methods of investing for retirement, such as employer 401k and 403b plans, and other ways to invest aside from the retirement goal. But hopefully it provides enough information to get your teen (or yourself if you are a teen) thinking about opening and contributing into a retirement account. I can't tell you what you should invest in, I'm not a certified advisor, but I can tell you that I do encourage my teen to invest into a Roth IRA with Fidelity and contribute into their FZROX Total Market Index Fund. This fund does not require a large initial deposit to start investing. I have my investments at Vanguard with a large share in their VTSAX Total Market Index Fund, but this does require a $3,000 minimum investment. Either are great choices. I choose not to utilize a financial advisor because they typically retain up to 2% of your returns as fees. Run the numbers to see the impact of getting a 9% return over 40 years versus 7% over 40 years. The difference is HUGE! Since very few professional financial advisors consistently outperform the market in terms of return rate and fail to justify the percentage of money they skim from the investment account, I feel this investment strategy is best for reaching my, and my family's, long-term investment goals.

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