Compounding has been called “The most powerful force on earth!” by none other than Albert Einstein, one of the smartest men of the 20th century. He certainly knew about “Forces”, at least in physics, but he was also well schooled in financial matters and he considered compounding a magnificent invention of the financial world.
Compounding is a financial term bandied about that essentially means earning money on your earnings. Most people associate the concept with Interest, as in Compound Interest. You put money in a savings account at, say, 5% interest, and, for simplicity’s sake, it compounds yearly. The earnings on $10,000 at 5% annual interest for the first year would be $500.
Compounding just means that the base on which you are earning that 5% resets to the $10,000 PLUS the $500.00. So, in year 2, the account earns 5% annual interest on $10,500, which works out to be $525, an increase of $25 over last year’s earnings. Now you’re earning money on your earnings!
This example represents a fixed rate of return, simple interest investment opportunity. At the interest rate and the amount invested in this example, you’d never get rich or earn anything truly significant. However, apply some of your specialized knowledge and compound larger sums of money at larger rates of return, you could start to generate some significant wealth.
For example, say you understand how to wholesale houses, one form of specialized investment knowledge. I have a few friends who are making some serious money doing this. It involves using a small amount of money to control a single family home through a contract to purchase, and then selling that contract to another investor for a markup of, say, a few thousand dollars. If you put $1,000 down as earnest money for the contract and then sell the contract for $6,000 to someone else, that’s a 500% increase on your investment. I know people who can do this multiple times a month.
Another form is to actually purchase the house for $30,000, do a little bit of cleanup for about $1,000 and have some holding and closing costs of about $2,000, and then to sell it to another investor for $43,000. That $10,000 profit represents a 30% Return On Investment. This, again, can be accomplished in 30-60 days.
If you didn’t spend the profits and put them back into the bank to use for more investing, then you are using another form of compounding. This one is not a fixed rate of return and you may not earn money on your entire portfolio with every investment, but you can earn significantly higher returns with that specialized knowledge and do more and more transactions each month with the extra money you have.
Here’s what I mean. If you have only $1,000, perhaps you can do only one wholesale transaction in your first month for your 500% return. After that’s done, you now have $6,000 and you can do three in the next month. Now you’re up to, say, $21,000, for a 350% return. And that’s just in one month! You could conceivably do five or six wholesale deals in a month, but you start bumping into time being your limiting factor, not money. And if you did six wholesales a month at $5,000 profit for each one, that’s one heck of a living!
By the way, this is more than just compounding. This is building a business that will set you for life.
Now why am I talking about compounding on a blog for Self Directed IRAs? Because, of the tax consequences of earning the money we’re talking about are significant if the earnings are not sheltered in some way.
We’ve already talked about the fact that you can do Real Estate transactions in your IRA, including wholesale deals. If you do get up to five or six wholesale deals each month, do you really need that much to live on? Why not take one or two of those and do them in your Self Directed Roth IRA or your Solo 401(k) and let the earnings grow tax free? Then those high compounding rates will not be compromised by removing taxes every year.
And you can experience the true growth that compounding affords!