As 2010 winds down it is always good to think about your tax situation. You might be very pleased with your peer to peer investment gains for the year, but I have news for you. All the interest earned on your p2p investments is fully taxable.
The IRS Wants Their Share
Your interest income from both Lending Club and Prosper are treated as ordinary income by the IRS. So, depending on your tax bracket you will owe some money to the IRS come April 15th. The amount of money you will owe depends on numerous factors but here is an example to provide some hard numbers.
Let’s say you are single and have a $50,000 adjusted gross income (AGI). For simplicity’s sake we will assume some round numbers. You have a $10,000 investment in Lending Club and you earned a 10% return on your money. This means you generated $1,000 in interest income. But that is before the IRS takes their share. At $50,000 you are in the 25% tax bracket so the IRS will want you to pay them $250 (25% of your interest income). Depending on what state you live in you may also owe state income tax – in Colorado where I live the rate is a flat 4.63% (in California it would be 9.55%). Let’s assume a 5% state tax rate, so you would owe another $50 in state income tax. So this 10% return has been reduced to a 7% return and you have given up $300 of interest income.
Now 7% after taxes is still a great investment return but it is a long way from 10%, your actual return. No one likes sending cash to the IRS, but if you keep your investment in a regular taxable account you will have to pay these taxes. Luckily, there is a solution that is provided by one p2p lender: Lending Club.
The Perfect Solution: a Lending Club IRA
Regular visitors to the Social Lending Network will notice the banner ad at the top of the page touting the Lending Club IRA. I feature this ad most prominently on my site because I firmly believe that this is the best way to invest with p2p lending. Currently, Prosper doesn’t offer any IRA, so if you want to shield your investments from the tax man then Lending Club is your only option.
Personally, I think if you have a Lending Club account you really should have some or all of your investment in an IRA. According to Rob Garcia, Senior Director of Product Strategy at Lending Club, over 90% of IRA’s are opened by people who already have an existing Lending Club account. This makes sense because people can put in a small amount to test out Lending Club and then move in their retirement funds once they are comfortable with the concept. Garcia also points out that the average account size is $40,000 for an IRA and the returns range from 2.4% – 20.1% with the average return 11.4%.
I rolled over my wife’s entire IRA and 401k into a Lending Club IRA earlier this year and I will be opening another IRA in my name next year (I would do it this year but I have already committed my 2010 IRA contribution). The Lending Club IRA really is the best way to invest in p2p lending because you can avoid the demands of the tax man come April 15 and you get to keep all your interest income.