Unlike traditional “defined benefit” retirement plans (such as the pension plans that promise to pay you a fixed sum every month for the rest of your life after you retire), you’re responsible for deciding how much to contribute to your self-directed IRA each year. Obviously there’s a direct correlation between the amount you contribute to your self-directed IRA each year and how much you are able to retire with; the more you contribute, the more you’re likely to have when you retire.
Similarly, making the best possible investment decisions within your self-directed IRA can help you grow your account balance as large as possible. Within the IRA structure, you can choose ultra-safe or ultra-risky investments, or anything in between, in an effort to reach your ultimate goal. With a self-directed IRA you can choose investments in real estate, precious metals or private equity and loans – whatever is most appropriate for your individual situation.
But some people don’t fully appreciate the value that compounding (in other words, the value of time) will ultimately have on their self-directed IRA account balances. As an example, let’s consider the situation of an individual who opens their self-directed IRA when they get their first job. Let’s assume this individual contributes $5,000 a year to the account for each of the first 10 years that they are in the workforce. Assuming a 7% simple rate of return, their account balance will be roughly $74,000 at the end of those 10 years (not including any account fees).
But let’s say that person never contributes another dollar after year 10. Assuming the same 7% rate of return (and not taking into account any applicable custodial fees), after 25 more years the account balance will have grown from roughly $74,000 to over $400,000.
This is the power of compounding.
The longer you give your account to grow, the more it can gain each year, even if you don’t make any additional contributions.
This isn’t to say that your contributions are not important, or that you shouldn’t be doing everything you reasonably can to maximize your contributions each and every year. In fact, quite the opposite is true. The more you can contribute, the greater the compounding effect you’ll experience over time.
There are several easy to understand and follow take away points that flow from this concept. The first is that you should open your account as soon as possible – this gives the greatest amount of time to grow. The second is that you should contribute as much as possible each year, but especially during the early years that your account is opened. Finally, with all other factors being equal, you should open a self-directed Roth IRA instead of a self-directed traditional IRA; you won’t be subject to the rules on required minimum distributions, so your account can continue to grow four more years.
If you’d like to discuss these concepts further, contact Quest Trust Company.
Quest Trust Company helps change people’s lives and financial future through self-directed IRA investment education. Quest Trust Company helps people invest in what they know best and build their financial future on their own terms.