Making a million in retirement off a summer job seems to be too good to be true. It isn’t. This example illustrates two important savings principles. Firstly, to start saving early. Secondly, to save tax-efficiently. Combine both with a robust rate of return and the results may well surprise you.
The Magic Of Compounding
Compounding is a powerful force and the numbers can be surprising. It is something Albert Einstein allegedly called the “eighth wonder of the world.” Compounding is earning extra returns on your returns. If you save a dollar, the next year you may have a dollar and five cents. That five cents earns a return too, and so on. In a single year it doesn’t make much difference. However, over decades that compounding really adds up. It means that your savings can grow, not just in a straight line, but in a line that curves up and keeps getting steeper. For example, if at age 20, you save a dollar and earn a 7% return on that money, then by age 70 that amount will be worth twenty nine dollars. Turning a single dollar into twenty nine dollars is not bad. Of course, we do have to be careful with these numbers, first off, steady growth is required, which can be hard to achieve, and secondly a dollar today probably is worth a bit less in future decades due to the impact of inflation as costs go up. Still a long-term return of 7% after inflation isn’t impossible, with a more aggressive asset allocation if history is any guide. Though right now, achieving that return in the U.S. stock market for the next decade or so may be a challenge.
How Roth IRAs Can Help
Compounding is one part to reaching a million, tax-efficiency is the other. This is where the Roth IRA comes in. The government wants you to be a saver. That’s one reason Roth IRAs were created. Here we are not breaking the tax rules, but using vehicles created to help people save. A Roth IRA doesn’t make sense for everyone and not everyone is eligible for it. Yet, if you’re in a low tax-bracket, and expect to be in a higher one in future, as virtually all teenagers are, then a Roth IRA can be a good idea. A Roth enables you to put away money after paying the current tax-rate on the income and, essentially, if the rules are followed and don’t change, then you may never pay tax on it again. Your income must be under approximately $120,000 depending on your tax filing status, but for virtually all teenagers doing part-time jobs, this shouldn’t be an issue. Plus, the maximum you can put into a Roth in any tax-year is currently $5,500. Finally, there a limited set of uses for the money such as retirement, college costs or emergency scenarios or even a first home if conditions are met. If you use the money for something else, or don’t follow the rules in some other way, there may be a penalty to pay and some of the returns on the money may need to be paid back too.
Of course, this technique is not without its challenges. The first is simply that as a teenager the temptation to spend money and not save is strong. Even if you’re at home with food provided, there are still things to spend money on whether technology, entertainment or travel, and focussing on saving that you may not see the benefit of for around five decades is a tough call for many teenagers. Also, finding a robust way to invest, perhaps through inexpensive ETFs requires some homework. However, saving is a great habit to start.
Then aside from saving enough, simply earning enough with a teenage job can be a challenge too. To reach a million at age 70, you need to save around $5,000 each year between the ages of 14 and 20, so just under the Roth contribution limit. If you earn $15/hour that’s 6 hours each week, or almost a full-time schedule over the summer months. Furthermore, college isn’t even considered here, the reason a lot of kids aren’t jump starting their retirement is because they money they put aside will more than likely help them with college first, or perhaps a down-payment on a home. Retirement is a long way off when you’re a teenager.