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SEP-IRAs: A Primer and a Funding Strategy

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[The following is a guest post by RateLadder.com. I asked him if he would be kind enough to write an article about the SEP-IRA since he has more expertise in the area than I do. He's also taking an approach that I though readers would find interesting. If you are interested in peer-to-peer lending, I highly suggest subscribing to his feed]

A Simplified Employee Pension Plan or as it more commonly called SEP-IRA is a retirement plan for self employed and small-business owners. It works much like a normal IRA in that earnings grow tax-deferred.

For those without a 401K with matching (401Ks are prohibitively expensive for small business owners) the SEP-IRA is your best pretax retirement vehicle.

There are a series of complicated rules as to how much can be put into the plan tax deferred, but to make it simple you may deduct from a maximum of $45,000 in 2007 and to make it more complicated depending on your particular situation the amount that can be deducted is between 18.6% and 25% of your income/net profit/W2 wages.

Blah Blah Blah why do I care?

1 word: PRETAX

The pretax portion of the SEP-IRA is what makes it so attractive to non 401K users. By deferring taxes you not only save in cash flow today, but push out the dollar cost of your eventual taxes so that their NPV is significantly less even if you are in a higher tax bracket in retirement. And on top of that you get the value of compounding interest.

I am taking out a loan to fully fund my SEP-IRA. How can this be a good idea? The details are more complicated, but let's examine the loan request and the ramifications -

Assumptions:
"¢ A loan is required in order to fund the SEP-IRA
"¢ $24K loan 3 years at 10%
"¢ 25% tax bracket now and in retirement
"¢ 30 years to retirement
"¢ 8% account growth rate
"¢ 3% inflation
"¢ 3 loan term not adjusted for inflation (by not adjusting I am imposing a small penalty on the benefits side of the equation).

Costs:
$24,000 = loan principal
$120 = 0.5% loan origination
$3,879 = finance charges
$55,904 = eventual taxes owed
$92,126 = inflation adjustment for future earnings NPV with a 3% annual discount

Total Costs: $176,029

Benefits:
$6,000 = immediate tax savings $24K * 25%
$223,615 = growth of $24000 tax deferred @ 8%
$23,032 = inflation adjustment for future taxes NPV with a 3% annual discount

Total Benefits: $252,647

Benefits "“ Costs = $76,618

You could add all kinds of complicated scenarios, but bottom line is that the origination fee and finance charges over the next 3 years are overcome immediately by the tax savings. And the long term benefits of tax deferred compounding interest make any short term pain from an affordable loan payment worthwhile.

Last updated on June 21, 2010.

This post deals with: ... and focuses on:

Retirement

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22 Responses to “SEP-IRAs: A Primer and a Funding Strategy”

  1. WealthBoy says:

    NICE! On the surface, if you told me you were taking out a loan with a 10% interest rate to put into an investment gaining 8%, I would tell you that you are crazy. I love that the immediate tax benefit more than makes up for it. It’s quite a brilliant idea, I must say. You could also use the $6k from the tax benefit to pay down the loan. It will save you $1,193 in interest and you’ll have the loan paid in 26 months.

  2. Chrisfs says:

    Have you run the numbers if you loan ends up funding at 12% rather then 10%

  3. C. Ward says:

    But what about a SEP-IRA contribution for next year? And the year after that?

  4. RateLadder says:

    @chrisfs
    The finance charge goes to $4,697.19 which does not materially change the equation.

    @C.Ward
    A totally valid question, up until late spring I had been making regular contributions. I got to the point where the stock market was too high for my comfort so I stopped. I will likely pay off this loan early. but I was trying to keep the numbers simple for the post. But assuming you can afford the payments then you could take out a 3 year loan each year and benefit from the tax deferred nature of the account.

  5. pfodyssey says:

    Assuming one can afford the payments, why would you ever fund it any differently? Seems the tax savings alone pay for the expected interest. Sounds like just another form of arbitrage, no?

  6. bubba says:

    I’m not sure I’m understanding where you’re getting this from:

    $6,000 = immediate tax savings $24K * 25%

    Is it because the money is pre-tax or are is the interest on the loan deductible?

  7. RateLadder says:

    @bubba

    The money put into the SEP-IRA is pre tax. (assuming you meet all of the qualifications yada yada).

    So by putting 24K into a SEP-IRA I am immediately reducing my taxable income by $24K. If my tax bracket were 25% (see assumptions) that results in an immediate $6K benefit from putting the money into the SEP-IRA.

  8. Irina says:

    Forgive me, but I thought that you can only contribute in your self-employed SEP-IRA or 401K from your earned income. Did I miss something? (I have a self-employed 401k with TRP.)

  9. Lazy Man says:

    I know that RateLadder has self-employed earned income to report. My guess is that he hadn’t been contributing up into now and realized that he has the opportunity for a tax break.

  10. C. Ward says:

    Whenever I read an idea like this, I can’t help but think someone’s rationalizing a situation far too much – to the point where they’re overlooking some serious issues.

    The best way to fund your retirement is to make regular contributions from your income. You’ll have the same benefits as the scenario (even the immediate tax savings!) without the cost or risk of the loan.

    If you can’t afford to do that or do not have the willpower to do it, then address those issues first.

    It frightens me that people out there make suggestions like this because other people will follow them without understanding what they’re getting into. I mean, if you’re going to borrow to fund retirement, why not take from your home’s equity, right? Then the interest you pay on your loan is even tax deductible!

    Talk to a licensed Financial Advisor you trust if you have questions about this. Don’t take advice from a blog.

  11. WealthBoy says:

    @C. Ward
    I agree that the best way to fund a retirement account is with regular contributions. The loan is not that different, as you could consider the loan payments to be regular contributions. The only difference is that the “contributions” (repayment) made via the loan will have an interest component that will not contribute towards the retirement account.

    In my opinion, the best reason for doing what RateLadder is doing is to make the maximum annual contribution for last year before the deadline on April 15. Perhaps he is perfectly capable of contributing $24k within 12 months, but does not have 12 months to do so. Taking out a loan in order to make the deadline is perfectly legitimate in my opinion.

    The thought of using a home equity loan vs. a Prosper loan had crossed my mind as well, in order to take advantage of the deductible interest on the home equity loan. In this scenario, if he were to use a home equity loan @10% amortized over 36 months, the home equity loan would bring an additional $970 in tax benefit over three years. Of course, if he pays the loan within 12 months it would be less than that.

  12. moneymonk says:

    You left out RISK, things happen you are able to pay back the loan, you are late on some payments, etc.

    It looks nice on the surface. You just decribe it, if everything goes perfert. Risk is always a factor when borrpwing money. You are a slave to someone for 3 years

  13. Lazy Man says:

    It doesn’t necessarily have to be a 3 year loan. He can pay it off in less than that. I know Kevin a bit and he’s got a few income streams diversifying his risk.

  14. RateLadder says:

    @moneymonk

    What risk? The risk that I wont pay off me loan? Or the risk that I won’t have enough in retirement? There is always risk. I was intentionally simplifying the scenario so that I could come up with an easy example.

    Regardless of what you think about my pretax contribution to a tax deferred, (I hope we aren’t questioning the merits of the previous portion)

    I am making $6,000 (pre tax savings) – $3,999 (finance charge plus origination fee) = $2,001 on the transaction.

    Make sure you read the assumptions again. How is this a bad thing?

  15. RateLadder says:

    And if I were a betting man :)

    I would bet that my loan ends under 10%. So I will actually pay less in finance charges than in the example.

  16. moneymonk says:

    The risk that I wont pay off me loan. However, it you can buckle down and pay off the loan very fast, the risk becomes minumum

  17. WealthBoy says:

    @moneymonk
    If RateLadder were to default on the loan it will have provided an even higher ROI than he has outlined. Of course, it would be to the detriment of his credit rating but it would still provide a better return nonetheless. If he became subject to a lawsuit to recover the loan, as long as he paid back less than the original loan amount (including any court costs, attorney fees, etc.), it would still provide a better return.

  18. RateLadder says:

    @WealthBoy & moneymonk

    RateLadder is not defaulting on this or any debt.

  19. RateLadder says:

    @ LazyMan

    thanks for having my back

  20. WealthBoy says:

    @RateLadder
    Touché
    I should have qualified my statement by saying something along the lines of “and that’s a BIG IF.” :)

  21. Foobarista says:

    There is such a thing as a Self-employed 401K that one can have if one doesn’t have employees (other than family members). It is about the same paperwork as a SEP-IRA. SE401Ks have significant advantages over SEP-IRAs, especially since the first $15,500 in self-employment income can go into a SE401K.

    My self-employed wife has had one for years. It is just a general brokerage account like any IRA; the only difference is we have to keep track of the “employer profit share” versus the “employee contribution”. She nets about $80K per year and we can put about $30K of it into the SE401K.

    A “general” employer 401K _is_ harder to set up.

  22. annuities says:

    it would be to the detriment of his credit rating but it would still provide a better return nonetheless. If he became subject to a lawsuit to recover the loan, as long as he paid back less than the original loan amount

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