Compound interest is a topic that has fascinated and excited retirement investors for hundreds of years. In fact, understanding about compound interest is many centuries old. Benjamin Franklin, for example, left an endowment in his will that would accrue interest for some 200 years. At the time, Franklin donated one thousand pounds. By the time the investment matured in the late 20th century, the Boston endowment was worth over $5 million. Another endowment to Philadelphia was worth about half of that.
Setting aside the issues of calculating inflation dating to the late 18th century, one lesson is clear: investors who put money in investments early on stand a greater chance of realizing spectacular returns when they retire decades later. Compounding returns create an exponential effect in which the whole is greater than the sum of its parts.
What does this have to do with a Self-Directed IRA? Well, it is easy to imagine how a company 401(k) can grow with compounding returns, especially if funds are held within a simple mutual fund investment. As the stocks average a healthy return over time, the investor—hopefully putting money away every month for decades at a time—will eventually realize just how powerful compounding returns can be.
But what if the investor in question does not want to invest in specific stocks? Let us look at some of the peculiarities of thinking about compound interest in different ways.
Compound Returns Through Other Asset Classes
Real estate has been a popular investment for millennia. The old adage is that buying land is a powerful way to invest because supply is limited, and demand is only going up as the population grows. But does this lead to compounding returns?
Consider a retirement investor who makes an investment in a single-family rental home. If this investor chooses correctly, it is possible that this investment could return them 10% per year in profit—although this is just a hypothetical example. While the value of the real estate itself may fluctuate, that real return of 10% every year is valuable.
That profit, then, can be reinvested over time. It functions in a similar way to stocks offering dividends. Many investors collecting a 4% dividend on a stock, for example, will simply reinvest that dividend to buy more stock. Owning more stock means more dividends during the next quarter, and over time, the returns become greater and greater in absolute terms.
The same principles hold true with real estate, if investors can find opportunities that generate consistent returns. Generating rental income within a retirement account also means that investors won’t have to pay taxes on the money that comes in through retirement investment income—at least, not until that money comes out of the account, depending on the individual quirks of the account. In the case of a Roth IRA, there may be no taxes on the back end, since investors are investing non-deductible contributions on the front end. That is money that has already been taxed.
Simply put, as long as an investment creates growth in a portfolio, it’s possible for compounding returns to come into effect. But keep in mind that different asset classes, available for investment within a Self-Directed IRA, can function very differently. With a Self-Directed IRA, you are the one in charge of making sure that retirement returns such as rental income are then reinvested somehow. And you are in charge of deciding how that money gets reinvested, or whether you want to reinvest it at all, depending on the situation.