Understanding the power of tax-free compounding
The benefit of tax-free compounding cannot be stressed enough, and while the concept may be esoteric to those that are unfamiliar with how it works, the best way to get perspective on its significance is looking at a possible scenario:
Meet John. John made a series of private loans over the course of a year. On the first loan, he made a 6-percent return on investment. On the second, he made 8 percent. On the third, he also made 8 percent. These transactions were all made back-to-back, with the first loan given to a rehabber (someone that purchases a property with the sole purpose of fixing it up/renovating it to sell it for a profit), which was paid back in three months, netting 6 percent.
Four days after being paid back, John deploys his money. He isn’t involved in the rehab; he’s simply the bank in this scenario, offering a loan with a first lien position on that property as well as a promissory note and a mortgage.
Over the course of 12 months with these funds, John makes a $12,000 profit, a 20-percent return on investment. Now, because he used his IRA for these investments, he is not going to be taxed. Had he used non-IRA dollars, he would have been taxed because it’s reported income.
Furthermore, John could take these profits, or at least the amount he saved from taxes, and roll that money into additional investments. And while some analysts dislike Roth IRAs because of missing out on tax deductions with each contribution, if the returns are significant enough, investors may make more money in the long term.
Increase your ROI and reach your retirement goals faster with an IRA
While there are benefits associated with buying properties with your self-directed IRA, there are some limitations for investors.
For one, flipping real estate may still have potential tax implications.
For example:
Kelly decided to buy a foreclosure property with her self-directed IRA for $100,000. She put about $30,000 worth of work into fixing up the property. After selling her property and factoring in all associated closing costs, she makes a $38,000 profit.
If Kelly invests outside of her IRA, she would pay about 30 cents on the dollar in the form of short-term capital gains tax (her ordinary income tax rate). This equates to $11,400 in taxes. Looking at this information from a yield perspective, her return on investment comes out around 20 percent compared to 29 percent in her IRA.
Increasing return on investment is one way to reach retirement goals in a shorter period of time, as outlined by the Rule of 72 concept, a formula that has been around for hundreds of years. The Rule of 72 is a simple, effective formula used by investors to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can obtain a rough estimate of how many years it will take for an initial investment to double itself.
Let’s use Kelly’s venture as an example: if she flips her property without her IRA and nets a 20-percent return:
72/20=3.6
This numerical value (3.6) represents how many years it will take for her money to double.
Suppose Kelly uses her self-directed IRA for the flip instead and nets a 29-percent ROI, how long will it take her to double her money?
72/29=2.48
Theoretically, Kelly will double her return on investment using a self-directed IRA in just over half the time it would take if she made the same investment without her IRA. Not only does this showcase how rapidly investors can increase their return on investments but also how effective compounding interest is in the absence of taxation.
Open a self-directed IRA with Equity Trust to start investing now
More and more people are discovering their investing potential by maximizing their IRAs while buying and selling real estate. If you’re still wondering which account is right for you, get in touch with Equity Trust Company and discover your options.
About James P. Schlimmer
James P. Schlimmer is the CEO of Equity Real Estate Services. Renowned as a pioneer in the real estate industry, Schlimmer has been paving the way for innovation in a field that has been stagnant and overly complicated for far too long. For nearly a decade, Schlimmer has worked diligently, assisting buyers and sellers by revolutionizing the closing process with a more modern, seamless approach.
Equity Trust Company is a directed custodian and makes no recommendations or representations as to Equity Real Estate Services and any information communicated by Equity Trust Company is for educational purposes only and should not be construed as tax, legal, or investment advice. Clients are in no way obligated to purchase services from Equity Real Estate Services and are free to purchase such services from any company as they deem appropriate. No customer may rely on any statement made by Equity Trust or any of its officers, directors, employees, or agents for any decisions regarding the use of the service offered by Equity Real Estate Services. Whenever making a decision related to your account, please consult with your tax, financial, or legal professional.
