When we talk about saving for retirement or other big goals, we often refer to the power of compound interest. Due to compound interest, the most important factor in building wealth isn't necessarily how much you save. It's actually how long you save for.
This is why it's so important to start saving as early as possible. While many people take that to mean starting a retirement account in your 20s, saving earlier than that can be even more powerful. Let's find out what would happen if your 10-year-old started saving just a little bit of money for a few years.
The scenario. Let's say your 10-year-old earns a little bit of money each month babysitting, mowing lawns or doing odd jobs. You enforce the idea of spending, saving, and giving. (Let's be honest, rare is the 10-year-old who will voluntarily decide to save for retirement.)
We'll say that each month your child earns $100. You require that she give $20 of that to charity, and then split the remaining $80 between spending and saving. So starting on your child's 10th birthday, she will put $40 per month into an investment account.
Let's say that this savings takes place every month from age 10 to 18. Assuming a 7 percent rate of return after taxes and fees, your child will have saved up $5,146 by her 18th birthday. And if she leaves that money in the same investments -- without adding another dime -- until she retires 40 years later, she will have $84,601. That is the power of compounding interest.
The results are even better if you save a small amount throughout your life. Let's say your child builds on those savings habits you instilled. Instead of adding nothing to that account for the next 40 years, she ups her monthly savings to $100 per month starting on her 18th birthday. Even with that relatively small increase, she'll have a whopping $349,291 in savings.
Is that enough to retire on? Probably not. But it's still a big chunk of change built on the foundation of early, small-time savings.
How to help your child save. Most young children aren't going to decide to save regularly on their own. Even if you show them these numbers, you'll likely have to enforce these good habits. But parents have a couple of good options to do this.
First, you'll need to decide how to approach the amount of savings. A good option is to set a certain percentage that your child needs to save. This percentage should be large, since your child isn't responsible for any necessary expenses, and should apply to all earned money or allowance. You might decide to deal with gift money differently.
Then you need to give your child a proper vehicle for saving. A regular savings account earning paltry.1 percent interest won't cut it. You won't tap into the power of compounding interest unless you're earning a decent rate.
One excellent investment option is a Roth IRA. You can open a custodial Roth IRA for your child as long as he or she is under age 18 and has employment income, which can come from some form of self-employment. A Roth IRA is a particularly good idea for children, since they probably won't incur much, if any, tax liability right now. You'll act as the custodian on your child's account until he or she turns 18. Contributions are limited to the child's earned income for the year, up to the $5,500 annual limit.
You can also boost your child's motivation to save by giving her a cash-back match. Say your child earns $100 from babysitting in one month. You require that she invest $50 of that in the Roth IRA. If she instead decides to invest $60, you can give your child an extra $5 in allowance to reward the savings behavior and encourage further investment. This creates a similar motivation to save as the tax break and employer match often associated with 401(k) plans later in life.
Abby Hayes is a freelance blogger and journalist who writes for the personal finance blog, The Dough Roller, which covers topics ranging from credit scores and banking to how much money you should be saving. Abby has written on behalf of Dough Roller for Credit.com and Mint.com. She has been writing about personal finance for seven years, but also covers topics as diverse as bowling, credit union management and parenting.