[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 –
“¢ 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).
$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
$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.