If you’ve successfully discussed money management with your child, and you feel your child is ready, consider teaching them the basics of investing. At the risk of oversimplifying an important concept, we bring you a discussion on investing that most children (age 8 and up) should have no problem following. You can share the article with your child or prepare a discussion based on these concepts.
Say you put $1,000 away in a box 10 years ago. Today, it has only $600 worth of buying power; that is, the bottle of milk that cost $1 just 10 years ago costs $1.60 today.
Since the purpose of money is to buy things, we measure the value of money by how much we can buy with it. So, if you put away $1,000 10 years ago when it could have bought you more, your money has lost value.
The loss of buying power every year is called inflation. Even a small yearly inflation of 3% or 4% will eat away at any money you save. So, you have to find a way to overcome the loss caused by inflation.
A credit union or bank will pay to use your money. If a credit union or bank pays you 3, 4 or 5% to use your money for a year, you will keep ahead of inflation … maybe. If inflation were 4% and you earned 4%, you broke even. If inflation were lower than the interest rate your money is earning, your money will grow.
Here’s another thing: The government takes about one-third of every dollar you earn in interest. This is called taxes. Between inflation and taxes, keeping money in a simple savings account is not the wisest course in the long run.
There are, however, other options that allow your money to grow at a quicker rate.
Interest earns interest: This is an exciting concept. Once kids understand the magic of compound interest, their own desire to invest grows.
Say you invest $1,000 at 5%. At the end of a year, it’s worth $1,050. But, at the end of two years, it’s worth $1,102.50. This is because the first year’s interest was $50 and the second year’s interest is another $50. In addition, the second year, you also earned $2.50 (5%) for the first year’s interest, meaning that your interest earned interest! At the end of five years, the original $1,000 is worth $1,283.
That may not seem like a lot of money, but if you let the same $1,000 stay invested at 10% for 10 years, it will be worth $2,207; at 20 years, $7,330; at 30 years, $19,842; and at 40 years, $53,715.
But … remember taxes? Uncle Sam trims off one out of every three dollars your money earns. So, instead of starting year two with 10% in interest, it’s 10% minus one-third.
To give you an idea of what that means, $1,000 invested at 12% with one-third of earnings paid to taxes every year would be worth about $90,000 in 30 years. Without paying taxes, that same $1,000 would be worth approximately $190,000. That’s a huge difference. If the government allowed you to pay taxes later, wouldn’t that be helpful? It would mean that you could earn interest on every dollar you earn without having to worry about taxes, at least for now.
Actually, the government does have such an arrangement. It’s called “tax-deferred” investing, which simply means you delay the obligation to pay taxes now. In the simplest program, you defer it to a later date.
You may have heard of IRAs and 401(k) plans. These are ways you can shelter, or protect, your investment from taxes. At the age of 59 ½, you can use the money and pay taxes on just what you use. The difference in earnings between tax-deferred and regular taxed earnings is tremendous.
Start investing early, and you give your money more time to grow. If an 18-year-old puts $1,000 a year into an IRA account (at 10% interest) for eight years, for a total of $8,000, and never puts another penny in, the original $8,000 will be worth over $500,000 when he reaches the age of 65. Start saving at the age of 40, and the numbers are not nearly as high.
There is a lot more, of course, to learn about investing. But, by giving your child a basic explanation of how money, saving and investing works, you’ve given them the keys to learn more on his own and become financially independent.