Hugh F. Wynn
Financial Fairy Tales Can Come True (But They Need Some Pixie Dust)
The easiest path for a Millennial or Gen-Zer to become financially independent and retire early is to carefully select his/her parents.
The latest dream (occasionally realized) among millennials is to become financially independent and retire early (a movement called FIRE) – a dream about retiring before or by age 40. As I understand it, the plan is to retire from a 9-to-5 regimen, but not to quit working. In short, these folks want to spend the rest of their post-40 lives doing what turns their crank. Of course, this kind of independence from the grindstone requires money. It can be done, but because it does require money, it also requires a huge dose of discipline at a very early age – an ingredient missing in the makeup of many people, including I suspect, quite a few of these potential FIRE devotees.
The “Earned Income” Bugaboo
The easiest path, of course, is for a Millennial or Gen-Zer to carefully select his/her parents. I know! I know! I’m being a bit facetious here, but stick with me. These parents don’t have to be super-wealthy (like, Bill and Melinda Gates wealthy) or even Wall Street or Hollywood rich. However, having financially secure parents who possess an entrepreneurial spirit might help. After all, wouldn’t it be advantageous to have parents who could provide opportunities for kids to generate $6,000 per year (in after-tax income) to fund a Roth IRA – quite the challenge in my rather blithe example since the kid must have the means to generate real “earned” income.
Note to parents: Gifts don’t work. In short, the kid must generate his/her own income, file a federal tax return, and pay tax, if due, on the net earnings.
While we're talking IRAs, here's my synopsis of the SECURE Act recently passed by Congress. As of Jan. 1 of this new year, there are new rules and regs that affect the IRA funds you bequeath kids and grandkids.
What, you exclaim? A baby…a preteen…a teenager earning those kinds of bucks? That’s why I mentioned entrepreneurial parents. It’s not out of the question. If, for example, the family owns a business, they might hire the kid to appear in commercials until said kid can perform other tasks for the company – or for third parties. By the way, an advantage to the family business is that the kid’s income is tax-deductible and more than likely taxed at a kid’s lower rate.
Part of the discipline I mentioned earlier is that the parents work hard at instilling in their kid a “savings mindset” such that the kid will continue setting aside $6,000 (the 2020 IRA limit) of their annual earnings for a Roth contribution. This is important because, as the kid matures, he/she will be able to earn larger amounts of net income, and hopefully, will want to continue to contribute $6,000 of this income stream annually to the Roth IRA.
A Fairy Tale Example
Now, I know my “parent selection” example is farfetched (after all, it is a fairy tale), but where there’s a will, there’s a way. One thing that works in parents’ favor is a constantly swelling account balance in the child’s Roth IRA. Let’s throw out some fairy tale numbers befitting our fairy tale example, which assumes an annual $6,000 contribution (beginning at birth). Let’s invest it in a Vanguard Total Stock Market Index Fund and further assume a 7% annually compounding rate of interest going forward. All things being equal, this plan will produce $260,500 after 20 years, $1,312,400 after 40 years, and $7,919,400 after 65 years (in each case before inflation). And because this is a Roth IRA, no taxes are due on all distributions from the account (once a kid reaches retirement age). But beware of certain withdrawal penalties that come into play prior to reaching age 59½.
Compounding…A Wonderful Thing
Aside from producing over $1,000,000 by age 40, my example also demonstrates The Amazing Power of Compounding, the “greatest force in the universe”, according to math genius, Albert Einstein. Additionally, it demonstrates the importance of my own PDQ Principles…Patience, Diversification and Quality…and a little bit of parental luck-of-the-draw. Not one in 10 million families will follow this fairy tale example using good and valid excuses, but why agonize over the loss of $7,919,400? It’s only money (and a stress-free retirement).
My fairy tale point is this, a kid has the advantage of time over adults. For this simple reason, even less than maximum contributions to a Roth can expand exponentially due to exposure to The Amazing Power of Compounding for a long period of time. And youngsters who receive parental encouragement to save (like I did) are more likely to develop good financial habits – habits that increase their future chances for financial stability.
In a future blog, I will present a more age-specific and detailed version of how to use a Roth IRA to build wealth for kids. A version that fits my blog’s primary premise: Because time is money and money is time, it’s crucial that young people start saving (and investing) early in life to optimize The Amazing Power of Compounding. Little else matters in personal finance until we learn not to violate this fundamental principle.
Fair warning to parents who don’t encourage their kids to save and to develop good financial habits. In 2017, $86 billion of student loan debt was owed by Americans aged 60 and over (Source: TransUnion). Some of this debt resulted from older folks going back to school for retraining in the wake of the recent Great Recession. But much of it resulted from parents taking out loans to help pay for their kids’ college expenses.
It’s now timely to replace my rather far-fetched fairy tale scenario with a big dose of reality. Which means it’s time, in future blogs, to take a harder look at Index funds and those fantastic IRAs mentioned in this and previous blogs.