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Why Your Teenager Should Have a Roth IRA

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why your teenager should have a roth ira

In 2002, I read Kevin McKinley’s book: Make Your Kid a Millionaire: 11 Ways Anyone Can Secure a Child’s Financial Future. One suggestion is starting an IRA for your kids when they start working.

Retirement planning for a 14 year old? Sounds like a crazy idea. But look closely at the math and you’ll realize those small contributions grow the most.

The reason this works? The amount of time the investment grows. Remember that Einstein is sometimes credited with declaring, “Compound interest is the most powerful force in the universe.”

Why not put this force to work in your family?

Since many teens are starting their first job this summer or working more hours now that school is out, let’s look at why a working teenager should have a Roth IRA.

1. Good habits start early.

Teaching a working teen to budget their income is a good lifetime habit. Under the three big categories of Give, Save and Spend, a Roth IRA contribution falls under the Save area.

The Average American only has $35,000 in retirement savings and saves around 3.7% of their income. That is way short of the advised 10-15% for retirement savings. Start a teen putting aside 10% or more for retirement now, and hopefully the habit will continue when that $200 paycheck becomes a $2,000 paycheck.

2. Time – the most important reason!

Small seed contributions today will become mighty retirement redwoods. Contributions in a Roth IRA during the teen years will be the portion that grows the most over the next 50 years.  Time is one of the most important elements of a successful retirement plan.

Example 1 from My Nephew’s Summer Internship

Ethan, age 16, contributes $500 from his summer internship over the next five summers. That $2,500 at 8% conservative growth will become around $137,000 at age 65.

If Ethan is able to put aside $1,000 over the next five summers at 8%, the balance will be around $275,000. A quarter million dollar retirement for the price of $5,000. That’s a big deal!

Example 2 from David Bach’s Automatic Millionaire

Terry contributes $3,000 a year from age 15 through 19 at 10% return and has a balance of $1,615,363 at age 65 from $15,000.

Kim starts contributing $3,000 a year from age 27 until age 65 and only has a $1,324,778 balance after $117,000 in contributions.

Example 3 from Financial Peace University

Ben, age 19, contributes $2,000 to a Roth IRA for 8 years at 12% growth. At 65, the account balance is $2,288,996 from $16,000 in contributions.

Arthur starts contributing $2,000 from age 27 through age 65 and has an account balance of $1,532,166 from $78,000 in contributions.

As you can see, time plays a very serious, important role in investment growth.

3. Pay little or no taxes now for a tax-free retirement.

A teen’s annual income typically falls within the lowest tax bracket – essentially making these working years the lowest taxed of their lifetime. It can also fall under the standard deduction so that very few taxes are paid at all beyond Social Security and Medicare contributions.

By contributing to a Roth IRA, your teen can have a nearly tax-free retirement contribution and growth. Withdrawals in retirement will be tax-free during a time when their income and the tax brackets will be higher.

4. Flexibility with life’s choices.

Starting a Roth IRA in the early working years gives flexibility down the road.

Stay-at-Home Parent

A stay-at-home parent will have financial peace of mind while they do the most important job in the world knowing their retirement is still growing. Even though a SAHP is eligible for a spousal IRA, the household budget might be tight on a single income for a few years with little or no extra for retirement savings.

Low-Paying Vocations

We all want our children to find and follow their passions in life – but many do not come with a high-paying job or a retirement plan. A Roth IRA that builds over 60 years with small annual contributions can grow into a decent retirement asset.

Disability

Pre-retirement age adults have a greater chance of becoming disabled than dying. Putting money to work early in a Roth IRA helps lower the risk of not having any retirement savings because you had to stop working right at the time when you were planning to start putting money aside.

Caretaker

Your teenager, in their adulthood, may have to choose between caring for someone or working. They might want to be a SAHP, homeschool their children, provide long-term care for a child with different abilities, and/or help with aging parents or other family members. Having a Roth IRA that continues to grow during those exits from the workforce can be a comfort.

How a Teen Can Open and Contribute to an IRA

Opening a Roth IRA Account

Since a teenager is a minor, an adult will have to help open a Roth IRA account as the custodian. In most states, the adult will have control over it until the teen is at least 18 years old. Vanguard has a $1,000 minimum deposit on an IRA account with limited investment choices but other companies offer a low-opening deposit with automatic monthly investing.

You need to research to find the right mix of investment options, low opening balance requirements, and management fees.

Teen Contributions

The working teen can set aside a portion of every paycheck to contribute to the IRA. A general rule of thumb for adults is 10-15% of take-home pay.

Matching Contributions

You may encourage your teen to put money in an IRA by matching your contributions. Talk about whether you are interested in matching 5-100% of their contribution to help kick-start their IRA.

Parent/Grandparent Contributions

Some teens receive gift or spending money from their parents or grandparents during the year. Their IRA contribution doesn’t have to be directly tied to their paycheck – the only rule is you can’t put more into your IRA than you earn up to a maximum of $5,500 in 2013.

This is a great way to pass down wealth without inheritance taxes.

Final Thoughts

Our teens have been working and building up a Roth IRA balance for the past nine years as part of our family’s big picture financial plan from a variety of contribution sources. While a portion of the contributions are from us, we feel like the gift of time and tax-free growth is worth more than the actual money given.

What would you tell a teenager about saving for retirement? Does a teen in your home have an IRA? Leave a comment!

What is Gross vs. Net Income?

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What is Gross Income vs Net IncomeQuickly, how would you would answer this question: “What’s your income?”

Did you think about the amount of your payday deposit? Did you think about the amount on your income tax return for the year?

One is your net income and the other is your gross income.

Everyone should understand the difference between gross and net income and why both numbers are important in your financial life.

Let’s review some of the common factors that go into calculating your gross and your net income – both monthly and annually.

Monthly Gross Income vs. Net Income

Your monthly gross income is what you earn at your job before any deductions. You can find your gross income on your pay stub. From this number, multiply by the number of pay periods per year and divide by 12 to get your average monthly gross income from that job.

Your monthly net income is your take-home pay – whether you receive a check or have direct deposit set up with your bank account. To calculate your monthly net income, multiply your take-home pay by the number of pay periods per year and divide by 12.

Your gross income can be reduced by items such as:

  • Federal income tax withholding
  • State income tax withholding
  • City income tax withholding
  • Social Security & Medicare withholding
  • Health insurance (or Medi-Share)
  • Union dues
  • 401(k) contributions

Why You Should Know the Difference on a Monthly Basis

For families and individuals, there are several reasons to know the difference between gross and net income:

Cash-Flow Planning

Household and personal expenses are going to be paid out of the net income  – while the money taken out for taxes, insurance and retirement savings is not available to pay the bills. Most household bills generally cycle each month and it’s easier to create a monthly budget using a monthly new income estimate.

Net Pay Per Hour

By dividing net income by the number of hours worked, you can calculate your net hourly wage. This is a good number to know for both hourly and salaried employees. When making a purchasing decision, you can figure out how many hours you need to work to buy a new TV or big vacation.

Example: Terry works a full-time job at $18 an hour. Payday is every other Friday. Terry earns a gross income of $1,440 over 2 weeks but has the following deductions:

  • Income taxes ($216)
  • Social Security and Medicare ($81.36)
  • Health insurance contribution ($75)
  • 401(k) contribution at 5% ($72)

Terry has a net income of $995.64 to use for cash-flow planning. When Terry works on a monthly budget, only about $2,157 ($995.64 x 26 pay periods / 12 months) is available to give, save and spend. Knowing the net income, Terry can budget out how much money is available for each category and for each item.

Terry brings home about $12.45 per hour in net pay ($995.64 / 80 hours).

Annual Gross Income vs. Net Income

Your annual gross income can include many types of income that are above and beyond your paycheck:

Your annual net income can be estimated during the year based on your net paycheck and estimating the net amount from the above items. Keep in mind that payroll tax withholdings are estimates. Only after completing your income tax return with all sources of income will you know the exact tax obligation.

Why You Should Know the Difference on an Annual Basis

By adding up all the sources of income for your family, you can use this information to:

  • Develop an annual budget for your family that includes all miscellaneous income sources
  • Develop an action plan for the misc. income so that money doesn’t just fritter away in the bank account
  • Plan for annual expenses such as insurance, car registration, Christmas expenses, and vacations
  • Develop good tax strategies
Knowing the gross and net income from specific job can help you make a decision about changing jobs or locations. When comparing the compensation packages of two jobs, it’s important to understand the effects from:
  • Taxing authorities
  • Tax brackets due to changes in income
  • Healthcare deductions
  • Bonuses and other perks

Example: Terry is considering applying for a different job within the city limits. The new job will have an additional city income tax of 1% and will require about $30 more in gas for the additional miles to the office every pay period. The new job offers lower cost health insurance and Terry is willing to contribute more to the 401(k) plan for the higher match.

The new job pays $21 per hour with deductions for:

  • Income taxes, increased by 1% city ($268.80)
  • Social Security & Medicare ($94.92)
  • Health insurance ($50)
  • 401(k) contribution of 6% to get full match ($100.80)

Terry’s gross income will increase each paycheck by $240 ($1680-1440) because the hourly rate is higher ($18 v. $21). However, net income will only increase by $170 ($1165.48-995.64) per paycheck.

Even with the additional $30 gas and higher retirement contribution, Terry will have more money to give, save and spend with the job change.

A Contractor’s Calculations

By definition, a contractor is not an employee and does not have estimated taxes, Social Security, or Medicare withheld from their compensation.

If you work part-time or full-time as a contractor, you should understand what percentage to set aside for taxes based on your household tax brackets. Self-employed individuals are required to pay “both sides” of Social Security & Medicare – so double the percentage of what is deducted from an employee’s paycheck.

Many contractors find it helpful to transfer a calculated percentage of income into a special savings account for taxes to save towards quarterly deposits and avoid a bite during tax season. A tax professional can help estimate tax payments based on income and likely business deductions.

Keep in mind that the calculations in this article are based on a specific set of circumstances, and your results will differ! So make sure to do the math yourself to come to the right figures for you in the current year.

Have you ever thought about the difference between your gross income and your net income in terms of either actual dollars or percentages? What did you do with this information?

How to Calculate Your Real Hourly Wage

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Have you ever figured out what your time is worth?

We make decisions every week on whether something is worth our time.  Almost all of us choose to work.  We go to the office, the shop, or the site in exchange for money.  We’ve already come to an agreement with our employer on what our time is worth.

But have you ever calculated your real hourly wage?  You might be surprised!  Once you find it out, you can use that information to make some adjustments in your personal and financial life that will result in real change.

The Real Hourly Wage Calculation

1. Give Uncle Sam his share.

Anyone who gets a paycheck knows that the government gets their money first:

  • Social Security
  • Medicare
  • Federal and state tax withholding estimates
  • Other states have small city or disability taxes withholding

Check out last year’s tax return to figure out the average percentage of your total income that went towards income taxes.

Example: Jon makes $20 an hour and pays an average of 11.5% in total taxes. Jon’s post-tax hourly wage is $17.70 for his time on the job.

2. Calculate the hours before and after the job.

A 40-hour a week job does not take up just 40 hours a week.  We need to add up the time that Jon puts into these extra activities:

  • Getting ready in the morning  – 2.5 hours a week
  • Commuting to/from work – 5 hours a week
  • Unpaid lunchtime and breaks – 5 hours a week
  • Decompressing at home after work – 2.5 hours a week
  • Evenings and weekends checking/answering cell phones and emails – 2 hours a week

Each week, Jon devotes an additional 17 hours to maintain his job.  This brings the total hours each week to 57.

3. Calculate the net wage for job-devoted hours.

Jon gets paid $17.70 post-tax per hour for his job – so his weekly paycheck is $708 (for the 40 hours).  However, we’ve just figured out that there are 17 more hours each week Jon needs to put into maintaining this job.

Divide the $708 paycheck by the total of 57 hours to get a real wage of $12.42 per hour – before expenses.

4. Add up the expenses of having a job.

We all have expenses related to going to work. For Jon, these include:

  • Car and gas expenses – 15 miles to work at the IRS rate of 55.5-cent/mile – $83.25/week (10 trips)
  • Required professional clothing, uniform, and grooming items – $20/week average
  • Dry cleaning & professional laundry services – $10/week

Total job-related expenses: $113.25

Each week, Jon devotes 57 hours to his job and doesn’t always have the time or energy for household chores.  Because of this, Jon pays for:

  • Housekeeping services – $20/week
  • Yard maintenance for grass, leaves, snow, fertilizing, etc. – $30/week
  • Car wash – $10/week average
  • Pet care for grooming – $5/week average
  • Lunches out twice a week because he doesn’t always take time to make it – $15/week
  • Take-out, convenience foods, and/or dining out – $50/week

Total expenses of services & conveniences: $130

We need to reduce Jon’s paycheck of $708 by $243.25 ($113.25+$130) of expenses to get his personal “profit” from working to $464.75.

Divide that by the 57 hours – and Jon’s new real wage ends up being $8.15 per hour.

5. Add in the cost to the working parent.

Many parents make the decision every year on whether to go back to work, work part-time, or stay at home with children.  It’s a tough decision based on many factors like the need for additional household income, desire to go back to a career, or a wish to be at home with the kids.

Let’s add in Jon’s childcare factors:

  • 2.5 more hours a week to drop off and pick up at childcare location
  • 5 more miles per day for commuting to childcare – additional car expenses of $27.75
  • $250 a week on childcare

Jon now spends over 59.5 hours a week in job-related activities – not including the extra driving time to and from childcare.

Let’s do the math of take-home pay of $708 minus work-related expenses of $141 ($113.25 plus additional $27.75 for gas), convenience expenses of $130 and childcare expenses of $250  – which brings us to a personal ‘profit’ from working to $187.00 for the week.

Divide $187.00 by the 59.5 hours and the average wage for hours devoted to maintaining a job has dropped to $3.14 – and keep in mind we didn’t count the commute time to childcare, figuring that he would be driving anyway for other activities if he didn’t have a job.

Are you surprised? Jon gives up almost 60 hours per week, has a job fairly close to home, only one child – and averages $3.14 per hour for the time he devotes to having a job.

6. Keep in mind the hard-to-calculate costs of working.

Working a 40-a-week job has many other costs that can be hard to quantify in terms of money:

  • Health costs due to lack of energy to exercise, prepare healthy meals, go to the doctor or dentist
  • Mental costs of stress in the working environment or worrying at home
  • Relationship costs from lack of time for spouse or family time
  • Personal costs due to lack of time for community interests, faith organizations, hobbies
  • Financial costs from not having time for money-saving research, mistakes for overdrafts or late bills, lack of energy for retirement planning

Do Your Own Calculations!

Your life is probably different than our example worker of Jon.  This is a good example to start filling in the time and expenses of your current situation to find your real wage.

Once you calculate your real wage, what will you do with that information?

  • Realize that a lower-paying job closer to home might result in the same real wage
  • Consider a career you’d enjoy more even though the pay is lower because you’ll have energy for family & household things
  • Decide whether to go back to work after having a baby
  • Understand that a part-time job can sometimes net bigger real wages
  • Be a stay-at-home parent and find ways to make money at home
  • Evaluate the relationship between pay, commute, and housing prices.

What is your time worth? If you aren’t spending your time doing something that furthers your passions, your family relationships, and your financial goals, then figure out where to make some adjustments that result in a real change.

Have you ever added up all the expenses of your job?  Did this type of calculation help you with decisions related to children?  Share your experience in the comments!

How to Manage Money as a College Student

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Campuses are gearing up for fresh-faced freshmen and returning students this fall.  Many college students have a limited amount of money – along with limited experience in managing money.  But the opportunities to spend are unlimited!  Here are some tips for managing your money as a college student . . . .

1. Learn to budget.

Budget is not a bad word.  Knowing exactly how much money you have to spend and what you need to spend it on will help avoid many problems.  Learn how to make a budget!

Income

  • Review your financial aid package carefully.  Student loans are a dangerous debt!
  • Determine how much of your savings (gifts, part-time jobs, etc) you plan to use.
  • Honestly estimate how many hours a week you can work and find out the prevailing wage in your area.  Don’t forget tax deductions.
  • Be creative about making money.  Tutor in a your strongest subject.  Offer to do other student’s laundry or cleaning for a fee.
  • Talk to your parents about their planned assistance.  Every family will help in a different way – and you all need to be on the same page about money expectations.  They might be willing to pay for specific expenses or give you a certain dollar amount.

Expenses

  • Estimates for tuition, dorms, off-campus living, and personal expenses for specific colleges on Collegeboard.org.
  • Check out your specific program for tuition premiums or additional tools needed for the classroom.
  • Think about the other things you will spend money on during the semester.  Know the difference between needs and wants.

2. Embrace the “poor college student” lifestyle.

There was a time when going away to college meant being a poor college student.  Money was very tight and most students embraced a lifestyle of limited means.  Now it seems that college life is a separate lifestyle and should equal and exceed that of living at home.

School Supplies

  • Research where to buy the cheapest books, whether online or at the bookstores.
  • Ask around to see if you can buy the book from last semester’s student – or sell yours to an incoming student.
  • Ask the instructor if you can use an older edition that is probably cheaper.  Don’t rush out to buy all the supplies listed on the syllabus – think about whether you can substitute or borrow.
  • Remember to sell your books back immediately after finals week.  Some online places like Amazon make it easy to sell books.

Food

If you have a prepaid food plan on campus, use it!

  • Understand the dining hall rules – some allow unlimited access and take-away boxes.
  • Some campus food locations and local restaurants will accept your dining points.
  • Pick the best food plan for how you will really use it.

If you are responsible for your own meals, this will probably be a new experience for you.

  • Invest a few hours a week in meal planning and shopping
  • Only buy what’s on your shopping list – and don’t fall for the fancy displays.
  • Never shop when you are hungry!
  • Find easy, cheap, and healthy recipes online.
  • Fix in bulk to save and add variety.  Pool your money and cooking talents with other student – prepare a good meal and split the costs.
  • Don’t waste food. Learn to use or spruce up leftovers – or freeze before it goes bad.  Get to know how much produce you use in a week so there’s limited waste.

Clothes

  • You own it – so repair it and wear it out.
  • Know your clothing budget to add a few seasonal items or replace necessities.
  • Get to know your local thrift and consignment stores.
  • Ask to ‘shop the closet’ of a friend for items you only need to use once for a special occasion.

Gadgets

  • Protect it!  Bring what you own to college and protect it with a desk lock and use those locking drawers in dorm dressers.
  • When you buy, get only the features you need at the time.  Technology is dated as soon as it hits the market.
  • Stay on your parent’s cell phone plan for the discounts – and send them your portion every month.
  • Be prepared!  Here’s a tip from my college daughter: save all your work to Google Docs in case of a computer accident or loss.  You may be paying to repair or replace your computer – but at least you won’t miss a deadline.

Furnishings

  • A poor college student takes things from home and accepts hand-me-downs from relatives.
  • You can buy one or two new items for your room or apartment that fit in your budget.
  • If you don’t have to move out at the end of every year, drive around the outskirts of campus during finals week and check out all the items left on the curb or near dumpsters.  Many students and graduates will only take what will fit on their car – leaving big items behind.

Utilities

For the first time, you are having to pay for utilities on your own if you just moved out of your parents’ house.  Here are some important considerations.

  • Understand what utilities are paid in the dorm/apartment and what you will be responsible to pay.
  • Learn to save on energy by turning off lights and washing a full load of clothes and using heat & air-conditioning only as needed.
  • Evaluate whether you really need cable TV if you tend to watch many items through the free Hulu.com.
  • Don’t forget – you can get streaming movies through Netflix.com for a lot less than cable TV.

Entertainment

Having fun is part of your college years.  But this can be the biggest budget buster of them all.  There is always someone ordering pizza, going out to get something to eat, heading to a movie, buying tickets to a concert, or planning a big weekend trip.
  • By budgeting an Entertainment category, you will know exactly how you can socialize.
  • Don’t be afraid to suggest other alternatives like a $1 Redbox rental, free events on campus, creatively cooking from the pantry, or a lowest cost activity.

Insurance

  • Health – Understand how you are covered by health insurance (or Medi-Share) and know how to use it – your parents’ plan or a student plan from school.
  • Belongings – Determine whether your parent’s homeowners policy will cover you or if it’s better to get an individual renter’s policy.
  • Automobiles – If you left your car at home, some carriers will suspend your premiums while you are away at college.

3. Remember to save.

It seems contradictory to ask a college student to save when they have limited money and might even be borrowing.  But even a small emergency fund can save the day with an unexpected expense or emergency.  Start good habits by putting away 10% of your paycheck or other assistance.

4. Remember to give.

Giving is important. Here are some ideas.

  • Give of your time to a campus service organization or new faith community.
  • Give of your talent in the tutoring center or helping a classmate.
  • Give of your limited treasure.

5. Avoid credit cards.

Credit cards are not the solution to too much month at the end of the money.  Pizzas, shoes, and movies can add up quickly.  After 4-6 years in college, you can easily be graduating with high-interest debt that could buy a good car.  Don’t turn a $20 pizza into a $150 pizza!

You will learn many things in college – inside and outside the classroom.  Managing your money is a skill you will use for a lifetime – so embrace this new opportunity to learn!

How did you manage money when you were in college?  How do you teach your college kids to manage their money?  Leave a comment below!