Does It Make Sense to Borrow for an IRA Contribution?
When you are considering where to invest for your retirement, the potential tax advantages of an IRA merit your attention. You may be able to contribute pretax dollars and accumulate investment earnings tax-free. Whether it makes sense to borrow money for an IRA contribution will depend on your cost to borrow that money and how you would have fared if you had invested an amount equivalent to your loan repayments instead.
Types and Limits
Before investing in an IRA, you must decide which type is best for you. A traditional IRA can allow you to contribute with pretax dollars, but your withdrawals will be taxable; they are a good choice if you need immediate tax relief and believe your tax bracket may be lower in retirement. Your contributions to a Roth IRA are made with after-tax dollars, but your withdrawals may be tax-free if you wait until after age 59 ½. These are a good choice if you wish to minimize taxes on your retirement income. In both cases, your maximum annual contribution to both plans combined is limited to $5,500 ($6,500 if you are 50 or older) according to the 2013 IRS rules.
If you borrow money for a contribution to a traditional IRA and you meet the income limits for a full deduction, the entire contribution (and thus amount borrowed) can be deducted for the year in which you make it up to and including the due date of your tax return, generally April 15th of the following year. If you instead made monthly contributions equal to the payments required to pay back a one-year loan, you could only write off the monthly contributions you made by April 15th for the preceding tax year and deduct the remainder in the next tax year. It would therefore be a significant advantage to invest a single larger sum of money in your IRA near the time you send in your tax return as you could benefit from the full tax deduction on that contribution. If you had tax withheld regularly from your paycheck, you would generate a tax refund generally equal to the amount of your contribution multiplied by your tax bracket.
When comparing the total dollars contributed over the period of the loan, you generally get little benefit from investing the loan amount compared to investing the monthly payments it would take to reimburse the loan over one year. The reasoning is that if you borrow money, you must pay interest on that loan and therefore the total monthly loan payments are higher that the actual amount borrowed. By the time one year has elapsed, you invested more total dollars on a monthly basis than with one deposit upfront with the borrowed money. The advantage of earning interest immediately on a larger upfront contribution with the borrowed money is mitigated over the course of one year by slightly larger dollars having gone in on a monthly basis.
Whether your borrowed contribution results in a higher investment value over time will depend on the comparison between your cost of borrowing and your average annual investment returns in the IRA. If you took out a $5,000 personal loan at an interest rate of 5 percent, your monthly loan repayments would be $427.78. If you earned an average return of 5 percent on your investments in the IRA, an immediate investment of $5,000 and twelve monthly deposits of $427.78 would both accumulate to $5,250 after one year. If, however, your investments only return 3 percent annually, your $5,000 investment would grow to $5,150 while your monthly contributions would grow to $5,203.60 because your cost of borrowing is higher than your investment return. If your investments return more than 5 percent, you accumulate more money by borrowing because your cost of borrowing is lower than your investment return.
Philippe Lanctot started writing for business trade publications in 1990. He has contributed copy for the "Canadian Insurance Journal" and has been the co-author of text for life insurance company marketing guides. He holds a Bachelor of Science in mathematics from the University of Montreal with a minor in English.