Compound Interest: Investing Inside an IRA vs. Outside an IRA
The following video highlights compounding interest in the absence of taxation utilizing a self-directed IRA or other retirement account.
Through a real estate case study example, the numbers can be applied to a compound interest calculation to demonstrate the analysis of an investment.
Compound Interest: Investing with an IRA
Watch the video to view a real estate investment example from an Equity Trust Company case study, as well as a hypothetical example that demonstrates compound interest with regards to private lending.
Compound Interest Calculation
In this specific compound interest demonstration, the equation used to calculate compound is:
FV = PV(1+R)N
Resource: Financial Calculators
In this segment we’re going to be talking about compounding interest in the absence of taxation utilizing a self directed IRA or other retirement account and we’re going to demonstrate this to you by utilizing a real estate investment example. Let’s get to the whiteboard.
So let’s whiteboard this showing a case study and then applying the numbers to the compounding interest calculation using our financial calculator.
Real Estate Compound Interest Case Study
So this case study is Michelle. And Michelle submitted this case study in 2019. She was applying for the 2018 investor of the year award that we give out every year. And Michelle gave us this transaction where she partnered three IRAs within her family. She had an IRA for her husband, an IRA for herself, and then her 19-year-old daughter.
Now you’ve got to make sure you do this properly. And we have another segment on partnering Multiple IRAs together. But in this transaction they had three IRAs all partnering on a deal to buy a property for $24,000, they bought a rental property for $24,000.
At the time of buying it, it had a current value of around $40,000, so they bought it at a discount for 24,000. And the present value calculation or present value figure that I’m using is $8,000 because her daughter put in $8,000 into the deal. So it was a $24,000 property purchase in each party, mom, and dad, and then the 19-year-old daughter with her Roth IRA each put in about $8,000 for the $24,000 purchase.
So we’re going to start at $8,000 and what we’re going to do is we’re going to make some assumptions, okay? This is a little bit of a hypothetical example, but we’re going to make some assumptions. We’re going to say, “Okay, if she consistently makes a 19% return on investment… ”
Because right now with this rental property as it’s cash flowing, the annualized return on investment is at 19%. So if we project this out over 20 years, consistently receiving a 19% return on investment, if we go over to this graph here, in her Roth Ira, she will have saved over $308,000.
Now you’re probably wondering at this time, “Okay, what’s the difference between this Roth in this traditional and then this taxable savings?” Well, we have our tax free account. We have our tax deferred accounts such as a traditional IRA. And then of course we have our taxable savings. So what do we mean by when we say taxable savings? What we mean by that is if we buy a property, we buy an asset and it’s producing income, in a general sense, we have to pay taxes on that income.
Compound Interest Calculation Example #1
And there’s different tax rates depending on the individual situation, whether it’s short term, long term capital gains, ordinary income taxes, and of course the individual themselves in what their current tax rate is. But all in, we’re looking at this equation here, our future value compounding interest equation. Future value equals present value times one plus R to the Nth power. That’s a number of years. Now, the one variable that we didn’t factor into this equation, and most people don’t factor in, is taxes.
So in our compounding interest equation, we need to factor in taxes. If we factor in taxes using this particular example, and we put in 20%, so if I factor 20% into my future value calculation, that’s only $156,000 because each year I’m paying taxes on a percentage of my profits. Therefore, I have less buying power for my next transaction, earning 19% year over year.
In a traditional IRA factoring in 20% upon the withdrawal, I will have 246 close to $247,000 because tax deferred means eventually when I take the money out, I have to pay taxes. And then again with the Roth IRA, I have over $308,000 close to $309,000 tax free in that Roth IRA.
Now Projecting Michelle’s daughter’s situation over 20 years, let’s then project this out even further to when she’s 59 and a half or older, all the money in that account after the qualified retirement age of 59 and a half can be taken out 100% tax free providing that she’s doing everything properly.
So this is a great illustration of showing you how compounding interest in the absence of taxation, whether traditional or Roth, can be a very, very powerful financial instrument.
Private Lending Compound Interest Example
So let’s move on to our next example. And this is a hypothetical example. Let’s say we have someone that’s interested in lending money with their self directed IRA. So in addition to people buying rental properties or buying, repairing, and reselling properties for a profit, we also have investors that are doing private lending where their IRA will loan money, they have a promissory note and a mortgage or deed of trust secured by that property, and then their IRA is receiving interesting come back into that account.
So in this example, I’m going to say that our present value is 50,000. So we’re starting with $50,000 and an IRA that’s going to be deployed for private lending opportunities. The number of years, I’m going to go ahead and plug in 20 years again. And our return on investment I’m going to say is 12%, all right? I’m going to say 12% return on investment over 20 years starting with $50,000.
Let’s jump over to our graph. In a tax free Roth IRA… Okay, this will be our Roth IRA or it could even be a health savings or a Coverdell Education Savings Account, that’s over $540,000 saved. So $540,000 safe. Now, if I look at the tax deferred accounts, traditional accounts, SEP IRA, simple IRA, that’s over $432,000. So I got to pay some taxes when I take the money out. And then in my taxable account. And I used a 20% tax rate. So if I’m lending money not using an IRA, as I’m collecting interest income, I have to pay taxes on that interest income.
Compound Interest Calculation Example #2
So let’s say I do all of my lending outside of my IRAs, it’s all in my taxable account. And let’s say I make $100,000 in interest income and I have a 20% effective tax rate. 20% of 100,000 is $20,000, so I make 100,000 and I got to write a check for $20,000 in taxes leaving me only $80,000. I do this in an IRA and it’s all tax exempt going directly back into the retirement plan. So again, plugging into our financial calculator here over the 20 year period earning a 12% consistent return on investment, I will saved over $540,000. Again, a representation of how powerful compounding interest can be in both a tax free and tax deferred environment.
Case studies are provided for illustrative purposes only. Past performance is not indicative of future results. Investing involves risk including possible loss of principal. Information included in the above case study was provided by the investor and included with permission. Equity Trust Company does not independently verify all information provided by third parties.
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