What is Compounding Interest?
Compound interest is the interest that you earn from interest. If you have used a retirement account to make investments, you probably already know of this term by putting it into action. For example, if your original investment is $1,000 and the interest you generate on the investment is 10%, you now have $1,100. Assuming you generate an annual compound return over the next five months, you will eventually have $1,610.51.
Compounding interest is also a central component in retirement saving. This is why so many financial experts talk about the advantages of making investments with a retirement account vs personal savings. Your original investment will gain interest, as will the interest on the principal investment.
The Eighth Wonder of the World
Professionals in the financial market aren’t the only ones toting the perks of compounding interest. Albert Einstein, one of the greatest minds in Science, once described compound interest as the “eighth wonder of the world” and reportedly called it the most powerful force in the Universe. There is a lot of power in compounding returns and it can even help you become a millionaire by the time you quit your 9-to-5.
Compounding Interest in a Retirement Plan
Compounding works the same way with any retirement plan you open, whether it’s a Self-Directed IRA, Solo 401(k) or Roth account. The major difference between retirement accounts is that they are taxed differently. For example, in the case of a Roth IRA, your investments and contributions will grow tax-free because you pay your taxes upfront. The gains and interest on your investments are tax-deferred in the case of a traditional IRA. Although you do not have to pay taxes upfront, when you take a qualified distribution, you will have to pay taxes on the investment’s income and gains.
Whether you have a Self-Directed IRA or a Solo 401(k), compound interest will significantly change how much you save for retirement. This is why we always recommend using your retirement funds to make investments instead of your personal funds. A self-directed retirement plan allows you to make investments your way, by investing in alternative assets like real estate, tax liens, precious metals and cryptocurrencies. Get started today if you haven’t done so already. The sooner you start, the more you will benefit.