Whenever you borrow funds to invest with, you must always compare the cost of borrowing to the return you expect on the investment to evaluate whether it makes sense. However, if borrowing money to make an individual retirement account (IRA) contribution, you must also consider whether a tax deduction is available for the contribution, and if so, how much income tax it will save you.
Cost of Borrowing
Regardless of the type of IRA or other investment you are thinking about borrowing for, the cost of borrowing always includes the interest on the loan. For all loans, you use the annual percentage rate (APR) of interest your lender charges. For example, if you are considering borrowing $5,000 at an APR of 3 percent with the intention of paying the loan back in one lump-sum payment after one year, your cost to borrow this amount is $150.
Roth IRA Contributions
One of the two common forms of IRAs is the Roth IRA. When you invest in a Roth IRA, you don’t receive a tax deduction for the contributions you make. Instead, you recognize the tax savings when you begin making withdrawals during retirement since the IRS exempts both the principal and income of each payment from income tax. Therefore, when assessing whether it makes sense to borrow money, you must initially compare the rate of return you expect on your contribution over one year to the interest charges. In other words, if your $5,000 contribution yields more than $150 in income, then it’s advantageous to borrow the funds and make the IRA contribution.
Traditional IRA Contributions
A different calculation is necessary when making the contribution to a traditional IRA. This is because some of your contributions to a traditional IRA are tax-deductible depending on your filing status and adjusted gross income (AGI). You still consider the $150 cost of borrowing and the income you expect to earn on the contribution, but you must also consider the money you will save with a tax deduction. Suppose you file as single in a year you can deduct a $5,000 traditional IRA contribution and report $30,000 of taxable income. Using the tax brackets for single taxpayers, your tax bill before claiming the deduction is $4,075. If you reduce your taxable income by the $5,000 contribution, your tax bill decreases to $3,325, which yields a total tax savings of $750. Reducing your tax savings by the $150 of interest you will pay on the loan still yields a $600 savings, which indicates that it makes sense to borrow the funds.
Dealing with Losses
You must always consider the possibility that your IRA contribution will lose value over the course of the year. Since there is no immediate tax savings with a Roth IRA, borrowing money for that type of investment is inherently riskier than for a traditional IRA. For example, since you still save $600 with a traditional IRA contribution after paying the interest on the loan, your $5,000 contribution can lose up to $600 in value, and you will still break even.
- IRS: Publication 590 – Individual Retirement Arrangements
- Bankrate.com; 2011 Tax Bracket Rates; Kay Bell; January 2011
- IRS. "Income Ranges for Determining IRA Eligibility Change for 2021." Accessed Nov. 5, 2020.
- IRS. "IRA FAQs—Contributions." Accessed Nov. 5, 2020.
- IRS. "2020 IRA Contribution and Deduction Limits Effect of Modified AGI on Deductible Contributions If You Are Covered by a Retirement Plan at Work." Accessed Nov. 5, 2020.
- IRS. "2020 IRA Contribution and Deduction Limits Effect of Modified AGI on Deductible Contributions if You are Not Covered by a Retirement Plan at Work." Accessed Nov. 5, 2020.
- IRS. "Amount of Roth IRA Contributions That You Can Make for 2020." Accessed Nov. 5, 2020.
- IRS. "IRA FAQs—Rollovers and Roth Conversions." Accessed Nov. 5, 2020.
- IRS. "Rollover Chart." Accessed Nov. 5, 2020.
Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.