Making Your Maximum Annual IRA Contribution at Tax Time

RateLadder made a guest post on LazyMan’s blog on a strategy he is using to fund his Simplified Employee Pension Plan (SEP-IRA). A SEP-IRA is a retirement plan for individuals that are self-employed, and thus do not have an employer sponsored plan (such as a 401k or 403b). Basically, he is taking out a loan in order to fund his retirement plan. The thing that I really like about the idea is that the tax benefit will more than pay the interest on the loan (even though it is a 36-month loan)!

Of course, the best way to fund your retirement is to make regular contributions towards a retirement account, such as a Roth IRA or traditional IRA. For 2007, the contribution limit for an IRA is $4,000. If you made regular monthly contributions, that would be $333.33 per month (plus an additional $0.04 somewhere in there). Although it is now 2008, it is still possible to contribute towards the 2007 limit until April 15 (individual tax return deadline). If you would like to max out your 2007 contribution before the deadline, do not currently have the money to do so, and you are capable of contributing $800 or so over the next 12 months, you may want to consider a strategy similar to RateLadder’s.

If you are considering a similar strategy, I would recommend you take the loan for a year. That way your payments will approximate those for the annual contribution limits and you will pay less interest. Let’s do an example with a few assumptions (similar to RateLadder’s):

  • Your current tax bracket is 25%
  • You have at least $800 in discretionary income to contribute towards retirement
  • You are funding a traditional IRA (although a Roth IRA is better for the long term, it does not have the immediate tax advantage that will be discussed below)
  • A $4,000 loan will be taken to fund the retirement account
  • The interest rate on the loan is 10%
  • You will be making the 2007 maximum contribution of $4,000 with the proceeds of your loan
  • The loan will be paid within 1 year

The monthly payments on a $4,000 loan that will be paid in 12 months will be $351.66. The total interest paid will be $219.96. The tax benefit from the traditional IRA will be $1,000. The net benefit from the strategy will be $760.04. If the monthly payments are only $351.66, why did I say you needed at least $800 in discretionary income to contribute towards retirement?

The strategy really only makes sense if you intend to max out your IRA contributions every year. So that means you will need to contribute an additional $416.66 per month if you are to max out the 2008 contribution limit of $5,000. Otherwise, you would have to take out another loan next year to max out the 2008 contribution, and you would be playing catch up each and every year. If you’re going to be taking out a loan every year, you may as well just start making regular contributions now until retirement instead of using the strategy I’ve described.

If you or your spouse already contribute towards an employer-sponsored plan (401k or 403b), there are limits to the amount that can be deducted on contributions made to a traditional IRA depending on your adjusted gross income (AGI). This will limit the amount of tax benefit for your contribution, but you can still contribute the maximum annual amount of $4,000. You can refer to IRS publication 590 for more information. The strategy could also be used to max out a Roth IRA, but you will not have the tax deduction benefit to help cover the interest expense of the loan.

Prosper.com is definitely a good place to get a loan. Although Prosper loans are 36-month loans, it is easy enough to make over-payments to pay the loan within 12 months. You could also use a home equity loan to fund the retirement account, and take advantage of the deductible interest as well! Whatever strategy you use to fund your retirement, it is important that you do it as soon as possible. The more time your money has to grow, the more comfortable your retirement will be.

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