A lot of things have been dubbed "the eighth wonder of the world," but compound interest is one thing that comes pretty close to actually fitting that description. Compound interest means the money you have on deposit earns interest, and the interest your money earns also starts earning interest. When you add tax-deferral to your compound interest in your individual retirement arrangement, your earnings grow even faster.
Individual Retirement Arrangement
While you might think of your IRA as an investment, it is actually a special type of holding account that you can put a wide range of investment products in. Think of your IRA as a cup. The cup can hold coffee, tea, juice or almost any other kind of liquid you choose to put in it. Your IRA is a container than can hold stocks, bonds, mutual funds, bank certificates of deposit or almost any other type of investment.
An IRA is a special type of custodial or trustee account. Financial institutions, such as banks, savings institutions, credit unions, insurance companies, stock brokerage firms and mutual funds, who are approved by the Internal Revenue Service can act as an IRA trustee or custodian. Whether your IRA can hold an investment product that pays compound interest depends on your IRA custodian or trustee. For example, an IRA trustee at a mutual fund company might only allow you to invest in mutual funds operated by the company, which might not include products that pay compound interest.
Compound Interest Products
Savings and investment products that pay compound interest include money market accounts and certificates of deposit. Such accounts, when offered by a bank, are typically insured by the Federal Deposit Insurance Corporation up to the maximum limits prescribed by law, making them among the safest of all investments. Super-safe investments like these typically pay low interest rates, but because of the power of compound interest even small investments at low interest rates can grow significantly if you have enough time. The sooner you start setting aside money in a tax-deferred IRA, the more time you'll have for the magic of compounding to work.
Some interest-bearing investment products that are available for your IRA might not pay compound interest. For example, you can buy high-yield corporate bonds for your IRA. Corporate bonds typically pay interest on a semi-annual basis, that is they pay interest twice per year. That interest would go into your IRA as a cash-equivalent. Unless you direct your IRA trustee or custodian to re-invest the free cash in your account, the interest payment would remain as cash and would not grow or earn any additional interest.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.