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By Barbara O’Neill, Ph.D., CFP®, [email protected]

Parents are generally a child’s greatest financial influence. Children are like “sponges” and carefully watch their parents’ financial behaviors (e.g., budgeting and credit card use), even when they don’t say anything. They also learn from family conversations about money and informal questions and answers.

As described in a previous OneOp blog post, Personal Financial Managers (PFMs) may get questions from service members about teaching children to manage money. Topics often include allowances, matched savings, and experiential learning from “financial activities of daily living” (e.g., ATM use and cashing a check).

One more topic that should also be in the mix is helping children build wealth with small deposits starting from an early age (e.g., pre-teens). One of the greatest financial gifts that parents can give a child is an early crack at compound interest and the potential to become a millionaire.

Below are seven key talking points about “head start investing” for PFM staff to share with military families:

  • Seven Figures is Possible- A child can become a millionaire, indeed a multi-millionaire, by investing in an individual retirement account (IRA) at an early age. The magic of compound interest over five decades (e.g., age 15 through age 65) can turn even modest regular deposits into a substantial nest egg for retirement.
  • Compound Interest is a BFF- Investment growth over five decades is phenomenal. If teens (or someone on their behalf) contribute $2,000 to an IRA for just five years from age 14 through 18, and never contribute another cent, they’d have almost $440,000 at age 65, assuming an 8% return. If $2,000 annual savings continue through age 65 (51 years total), a “head start IRA” would be worth about $1.75 million!
  • There is a Catch– Children, like all IRA depositors, must have earned income from a job or self-employment to fund an IRA. Gifts and allowances don’t count. Children can make an annual IRA contribution of up to $6,000 (in 2021) or the number of their annual earnings, whichever is less. “Head Start IRAs” can begin as soon as a child receives any sort of income, perhaps as early as age 10 or 12.
  • All Income Counts– In addition to paid employment, many children earn cash payments from activities such as lawn mowing, car washing, newspaper routes, and babysitting. Keeping a simple log of the date and payment for these activities (e.g., April 30, lawn mowing for Mrs. Smith, $25) is recommended to provide proof of earned income in the event of an income tax audit.
  • Parents Can Help Out- The reality is that most children who struggle to earn $300, $500, or $1,000 over the course of the year will not want to lock up their hard-earned money in an IRA for 50 years. That’s okay. Their parents or another benefactor can fund an IRA to the extent of a child’s earnings. Service members could use a portion of special pay, incentive pay, or hazardous duty pay to supplement children’s savings.
  • Roth IRAs are Advantageous- Children should almost unquestionably invest for retirement in a Roth IRA. Tax deductions are of little consequence at an early age compared to the appeal of tax-free withdrawals of money that has accumulated over 50 years.  Earnings from traditional IRAs, on the other hand, would be fully taxable at a child’s retirement age income tax bracket.
  • Earnings and Expenses Matter– The impact of earning a higher average annual return (e.g., 8% instead of 5%) and paying lower investment expenses overtime should not be underestimated. A long time frame, attractive investment yields, and low expenses (e.g., a 0.20% expense ratio on a stock index fund vs. 1.0% on an actively managed stock mutual fund) provide young investors with a priceless advantage: the potential for financial independence (i.e., having enough savings to live on without needing an employer paycheck).

For additional information about developing children’s wealth-building potential, review the Money As You Grow materials available from the Consumer Financial Protection Bureau.