First, let's cover the basics. The traditional IRA is a retirement investment vehicle originally designed to help individuals not covered by company pension plans. On January 1, 1982, the law governing IRAs was changed to make them available to anyone with earned income who also was under the age of 70½, whether or not the individual was covered by a company pension plan, profit sharing plan, or a 401(k), all of which are known as qualified plans. Remember, everyone with earned income can have an IRA and invest up to $2,000 every year.

Compound Interest

      When asked, "What is the most powerful force on earth?" Albert Einstein replied without hesitation, "compound interest!"  And more than 200 years ago Benjamin Franklin defined the concept as "the stone that will turn all your lead into gold." How does it work? It is simply earning interest on your interest, as well as your principle.

      Let's take a look at 40 years of compounding for two, twenty-five year olds. The first person makes a $2,000 investment for each of the first 10 years, while the second person waits until the 11th year to make a contribution and then continues for the next 30 years. Each portfolio compounds at 10% interest per year.

"You can plan for tomorrow
today but you cannot plan for
today tomorrow"

 


Year     Annual        Ending             Annual            Ending
                    Contribution   Balance                        Contribution                  Balance
        1          2,000               2,200               0                  0
        2          2,000               4,620               0                  0
        3          2,000               7.282               0                  0
        4          2.000               10,210             0                  0
        5          2.000               13,431             0                  0
        6          2,000               16.974             0                  0
        7          2,000               20,872             0                  0
        8          2.000               25,159             0                  0
        9          2,000               29,875             0                  0
        10        2,000               35,062             0                  0
        30        0                      235,886           2,000          126,005
        31        0                      259,470           2,000          140.806
        32        0                      285,417           2,000          157.086
        33        0                      313,959           2.000          174.995
        34        0                      345.355           2,000          194,694
        35        0                      379,890           2,000          216,364
        36        0                      417,879           2.000          240,200
        37        0                      459,667           2,000          266,420
        38        0                      505,634           2,000          295,262
        39        0                      556, 197          2,000          326,988
        40        0                      611,817           2,000          361,887
        Total   $20,000           611,817           $60,000       361,887

      As astounding as it may seem, the person who invested less money, but did so at the beginning of the compounding period, actually has over 50% more money than the person who invested three times as much.

Compound Interest With Tax Deferral 

With some exceptions discussed later (see the section on ROTH IRAs to see how to earn tremendous returns “tax-free”).  IRAs defer all taxes until money is withdrawn during your retirement. This means that you compound growth much faster than if you had to pay current taxes. If you remember from our example in the previous chapter, when you made your first investment your profit was reduced by almost 40% because of taxes.  Deferring or eliminating taxes allows you to grow your portfolio at an exponential rate.  The longer an IRA is kept going, the more this power can work to increase the value of your investments.

      Let's look at two examples. First, a self-directed IRA is set-up and funded with $2,000. Every year thereafter an annual contribution of $2,000 is made on January 1st. Assuming the IRA is earning a positive return, it will combine the magic of compound interest with tax deferral.

      Nobody knows what interest rates will do in the future. But if your IRA earned a constant 10 percent return, after 10 years your total $20,000 investment would already be worth $35,000, a $15,000 gain. After 25 years your $50,000 investment would be worth $216,000. In 35 years your $70,000 investment would be worth $596,000, a gain of $526,000!