The Value of Compounding: What Young People Need to Know

The Value of Compounding: What Young People Need to Know

January 04, 2022

You’re already aware of the importance of long-term investing and the benefits of making ongoing contributions to your retirement accounts. But are your kids and grandchildren? If they’re in high school or college, investing for retirement is probably the last thing on their mind. But if they see the benefits of starting earlier in term of dollars and cents, they’re more likely to get on board.

The key to this lesson is to focus on the benefits of compounding: how the growth of a portfolio could be significantly improved by reinvesting dividends and capital gains. You can use a variety of online calculators to calculate potential outcomes. 

Here’s a hypothetical example. Say your daughter was born in 2000 and you celebrated her birth by establishing a Roth IRA for yourself with a $4,000 contribution and invested the entire amount in an S&P 500 index fund. If you made no further contributions, your Roth IRA would be worth $18,840 when your daughter celebrated her 21st birthday (based on S&P 500 results through August 2021). That would be an average return of 7.41% per year. Note: These figures are in today’s dollars and don’t take the impact of inflation into account, which is shown in the chart below.

If that seems impressive, imagine how much more this account hypothetically could have grown if you made contributions every year during this timeframe. 

Using the scenario above, say you celebrated your daughter's birthday every year from 2000 to 2021 by making an annual contribution of $4,000 to your Roth IRA. Using the 7.41% non-inflated-adjusted annual return from the previous example, your Roth IRA would theoretically grow to a non-inflation adjusted value of $240,724 when your daughter turned 21 in August 2021.

Keep in mind that all of these are purely hypothetical examples and in no way represent real-world results for any particular investor. Index funds rarely fully mirror the returns of their associated index. And your results might have been very different depending on when your initial investment and additional contributions were made. And, of course, past performance cannot in any way predict future performance.

Starting their retirement journey early

Hopefully, your children and grandchildren will be impressed by these results. At the same time, they probably don’t have nearly enough money to contribute significantly to a Roth IRA. At least not right now.

However, if you have teenagers who are working you can give them a head start.

If they earn any income at all, even from a side gig or part-time job, you can establish a Minor Roth IRA on their behalf. Why a Roth IRA? Because they’ll never have to pay taxes on earnings when they make withdrawals at age 59½ or later.

They don’t even need to make their own annual contributions. Instead, you can contribute your own money, up to the total amount they earn in a year or $6,000, whichever is lower. For example, if your daughter earns $1,000 a year from her job as a summer camp counselor, you can contribute $1,000 to her Minor Roth IRA.

When your child or grandchild reaches the age of maturity in your state (usually between 18-21) you must transfer ownership of the Minor Roth IRA to them. At that point, it’s up to them to decide if they want to keep on contributing.

Hopefully, after showing them the two examples above and providing links to relevant online calculators you've found on your own, they can see for themselves how contributing even a small amount of money to their Roth IRA each year could harness the power of compounding to build their retirement nest egg.

Getting them into the habit of saving for retirement early on may also motivate them to start participating in their employer’s retirement plan when they get their first full-time job.

In fact, you might want to encourage them to contribute as much as they can to their retirement plan on a pre-tax basis and then give them additional money to make additional contributions to their Roth IRA.

Help is available

Of course, these decisions are not always clear cut. Your child’s income and tax situation might call for a different retirement savings approach. If you’re unsure, you may want to consult a financial advisor who can help you and your children and grandchildren get a plan in place to put the benefits of long-term compounding to work.  

 

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This article was authored by David Jaeger and Jeffrey Briskin. David is a financial advisor at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or djaeger@canbyfinancial.com. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.

 

This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. The S&P 500 Index is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. Forward-looking scenarios are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Talk to your financial advisor before making any investing decisions. 

©2022 Canby Financial Advisors