Young people rarely think of planning for retirement, but starting a retirement fund as early as possible is necessary in order to reap the maximum benefits of compounding interest. Many children are able to generate earned income, which is wages or self-employment earnings, through modeling, paper routes, baby-sitting, etc. If a child has earned income, that child is eligible to contribute as much as $2,000 a year to an individual retirement account (IRA).

If an 18-year-old invests $2,000 annually in an IRA through the age of 25, with an annual return averaging 10 percent, by the age of 65 the investment will have grown to more than $1 million. This figure becomes even more impressive when one takes into account that it was generated off of an initial investment of only $16,000. A taxpayer waiting until the age of 25 to start contributing to an IRA would need to invest $2,000 a year until retirement to have $1 million.

An IRA may be appropriate for a child who has no need of the invested money in the short term. For example, the child may qualify for a college scholarship, or be able to fund a college education through other sources. However, if a child does need access to those moneys, an IRA could prove to be more expensive than alternative investments.

The chief benefit of starting an IRA early in life is the value of the compounding interest, but there are other advantages as well. These include establishing a savings habit, planning for long- term objectives, and getting a tax deduction for the contribution. Still, the detriments of an IRA do need to be evaluated. Under existing tax laws, any withdrawal prior to age 59 1/2 are typically subject to a penalty on top of the income tax due. As a result of this, such funds would not be available for things like college and/or a down-payment on a house without incurring a substantial tax expense.

(c) Copyright 1995-2015 by TaxLogic