Minimize Taxes on P2P Investments

[The Mobile Mustachian]

Hello everyone,

I currently max out my 401K and IRA in stocks and bonds and have been investing some cash in Lending Club over the past three years in a taxable account. As the balance has started to build (about 9K now), I am starting to see the long-term tax implications as being not too favorable for me. Next year, I am planning on starting a self directed Roth IRA and putting some of my Lending Club funds there. However, is there anything else that you might recommend that I do to keep building up my taxable account balance that will allow me to offset the tax bill? I currently take the standard deduction as I don't have enough expenses to itemize (house is owned by a LLC that I jointly own with a business partner). I am married with no children. My wife and I work, but I also own a sole proprietorship that generates a small amount of side income.

One thing I just thought of is whether I could open a 529 and use part of the funds to invest in Lending Club. Anyone have experience doing this?

Thanks for your feedback. Please feel free to follow up with any questions.

[GGNoob]

I believe you can claim losses for charged-off loans, but last year was my first with Lending Club and I didn't have any charge-offs in 2013. I think this would be filed the same as losses from stocks with the max of $3,000. So look into that next year if you haven't already been doing it.

My wife and I each have a Roth IRA at Lending Club. I had a taxable account with about $7k in it before I liquidated it (using Interestradar.com's auto sell feature) and moved it to stocks. I figured any taxable investments I have should be in stocks so I pay less taxes. Not to mention stocks are more liquid and easier to get in an emergency.

I created a calculator to figure out my returns even if I couldn't claim losses in my taxable account. I don't know how accurate this is, but if it is, the results show the returns are still pretty good after tax.

Let's assume I have a balance of $10,000 with an average interest rate of 18.15%. Based on the filter that I used to invest, Nickel Steam Roller say's I should have a 3.03% loss rate. My tax rate is a combined total of 29.6%.

Here's my results:



So if I could get a 9.74% gain after taxes and losses, that's pretty good! But if I build this up long enough and big enough, the interest may push me into a higher tax bracket, so my after-tax returns will go down.

Because I want to reduce my taxes, I probably won't ever invest in a taxable LC account again. However, a taxable account is much easier to use than the Roth IRA through Self Directed IRA Services. I hate that changes to contributions have to be filled out in a form and faxed/mailed to them instead of just submitting something online, along with every other change to your account.

[milesdividendmd]

Thanks for sharing this.

You are wise to cut your losses and move on to more conventional investments.

You bring up an important point.

This is a great example of one of the many reasons that p2p is not a good idea for most investors.

There are  so many reasons not to invest in P2P including,

1. Tax inefficiency.
2. High credit risk(wait till you see the default rate during the next financial crisis.)
3. High fees. (Would you buy a bond fund with an ER of 1%?)
4. Uncompensated risk for poor diversification.
5. Illiquidity

Imagine if you'd just invested in VTSMX instead?  At worst you'd pay 15% capital gains, and at best (if you are below the 15% tax bracket) nothing.  And your gains would certainly have been higher even before taxes. 

The best advice is to keep it simple with equity and bond index funds. And if you like real estate, there's nothing wrong with REITS.

[GGNoob]

Thanks for sharing this.

You are wise to cut your losses and move on to more conventional investments.

You bring up an important point.

This is a great example of one of the many reasons that p2p is not a good idea for most investors.

There are  so many reasons not to invest in P2P including,

1. Tax inefficiency.
2. High credit risk(wait till you see the default rate during the next financial crisis.)
3. High fees. (Would you buy a bond fund with an ER of 1%?)
4. Uncompensated risk for poor diversification.
5. Illiquidity

Imagine if you'd just invested in VTSMX instead?  At worst you'd pay 15% capital gains, and at best (if you are below the 15% tax bracket) nothing.  And your gains would certainly have been higher even before taxes. 

The best advice is to keep it simple with equity and bond index funds. And if you like real estate, there's nothing wrong with REITS.

All of these are very good points. Right now my wife and I contribute only enough each month to hit $10,000 in our Roth IRA's by the end of year 2 (to avoid the $100 annual fee charged by Self Directed IRA Services). The rest of the money goes into Betterment and we'll switch 100% to Betterment once we hit that $10,000. Then we'll let things at Lending Club go for a bit and see how it goes. It's fun and interesting, but all of your points are valid and things I've thought about. But if you are going to invest at Lending Club, you should at least do it in an IRA to avoid unnecessary taxes.

Lately I have been considering liquidating and closing our LC IRA accounts...will just take longer and be harder to liquidate as the account grows. But honestly you aren't supposed to be trading notes at all with an IRA, but I do anyhow...since it actually allows me to.

[Honest Abe]

I've been pulling my taxable money out of Prosper. Too illiquid, too tax inefficient, and since they've let institutional money get dibs on the "good" loans, it's not worth the returns IMO.

[kyleaaa]

P2P lending is inherently tax-inefficient. You should prefer owning equities in taxable accounts and bonds in tax-deferred accounts. P2P lending counts as a bond.

[rmendpara]

Hello everyone,

I currently max out my 401K and IRA in stocks and bonds and have been investing some cash in Lending Club over the past three years in a taxable account. As the balance has started to build (about 9K now), I am starting to see the long-term tax implications as being not too favorable for me. Next year, I am planning on starting a self directed Roth IRA and putting some of my Lending Club funds there. However, is there anything else that you might recommend that I do to keep building up my taxable account balance that will allow me to offset the tax bill? I currently take the standard deduction as I don't have enough expenses to itemize (house is owned by a LLC that I jointly own with a business partner). I am married with no children. My wife and I work, but I also own a sole proprietorship that generates a small amount of side income.

One thing I just thought of is whether I could open a 529 and use part of the funds to invest in Lending Club. Anyone have experience doing this?

Thanks for your feedback. Please feel free to follow up with any questions.

Do you plan to use the account/earnings prior to age 60?

If yes, then leave it in a taxable account. The taxes suck, but it's still a nice way to have some spendable money that continuously earns money without much work (just set the filters and let it go and check on it periodically).

If no, then consider closing the account (stop reinvesting and withdraw as cash builds up). Then, open up a Prosper/LC account as an IRA rollover (no taxes until withdrawal... unless you roll over a Roth).

FWIW, I'm doing #2. I realized that even though I expect my account to average into ~9% return once it matures... the taxes will make it a real return of ~6.5%. That's not a bad return, but it just makes more sense to eventually open up an account as a IRA rollover. 3.5% just for reallocating an investment to a different account type? Yes, I'll take that any day.

I may one day open up a taxable account if I have extra cash and if it's a relatively small portion of my NW, but for now, I'll let this one wind down and plan on doing a rollover some time in 2015 (haven't decided whether it will be IRA or Roth). Probably $10k at least to meet the minimum no-fees threshold, and then just let it grow.

[beltim]

P2P lending is inherently tax-inefficient. You should prefer owning equities in taxable accounts and bonds in tax-deferred accounts. P2P lending counts as a bond.

This is like saying that because there's no state income tax in Florida, your after-tax income is always higher in Florida than in New York.  In real life, however, salaries are not equivalent in New York and Florida, and you have to take that into account.  Similarly, in this case you need to take into account the return, as well as taxes, when figuring out where to hold different investment classes.

As an example, suppose you hold a ten year bond yielding 3% and you're in the 25% tax bracket.  Your after-tax return, assuming you hold the bond to maturity, is .75*3 = 2.25% in a taxable account and 3.0% in a Roth IRA (a tax-deferred account is trickier to calculate because it also requires knowing your tax situation when you withdraw funds).  Now, let's compare that to a ten year stock return with 2% annual dividends and 7% annual capital gains.  Assuming the dividends are qualified, in a taxable account the after tax return would be .85*2 = 1.7% dividends and (1.07^10) = 97% *.85 = 82%, or 6.2% annually.  Now, let's compare the choices where we hold $10,000 of each, and figure out the best place to put the stocks and bonds.
Stocks in taxable, bonds in Roth:
Stocks: $1700 in dividends, plus end value of 18200 = $19900
Bonds: $13000
Total: $32,900

Bonds in taxable, stocks in Roth
Bonds: $12250
Stocks: $2000 in dividends, plus end value of $19700 = $21700
Total: $33700

As you can see, in this example you're better off putting stocks in the Roth account, even though they're "more tax efficient."  With longer time periods, the differential grows.