Compound interest is a powerful tool that allows modest contributions to grow exponentially over time. It works by reinvesting the interest earned on your money, so that you gain even more interest. This cycle of reinvestment and growth is what makes compound interest so powerful. When it comes to traditional IRAs, the same principles of compound interest apply.
Whenever investments generate interest or dividends, that amount is added to the account balance. This allows your account balance to increase even without making regular contributions. On average, traditional IRAs offer between 7% and 10% of annual returns, which can be magnified with the addition of time and money. The main difference between traditional and Roth IRAs is when your funds are taxed.
Traditional plans are funded with pre-tax money, meaning you only pay taxes when you start making withdrawals during retirement. On the other hand, Roth plans are funded with after-tax money, but all retirement withdrawals are tax-free. Some interest-bearing investment products that are available for your IRA may not pay compound interest. For example, you can buy high-yield corporate bonds for your IRA, which usually pay semi-annual interest.
That interest would be deposited in your IRA as a cash equivalent, unless you direct your trustee or IRA custodian to reinvest the free cash in your account. In conclusion, traditional IRAs can earn compound interest and benefit from capitalization over time. The two main ingredients of compound interest are time and money, and the more of either that is added, the more your initial investment will grow. Making regular contributions to your IRA certainly helps, but the real power of this type of retirement account comes from capitalizing on interest.
