If you are new here, you may want to subscribe to the site RSS feed or visit the site map. Thank you for visiting!

Which should you purchase Prosper P2P loans (assuming your skilled enough to earn a 12% return) or the S&P500 which has earned 13% per year over the last 20 years? The answer is not simple and it depends greatly on taxes. I will provide you with a spreadsheet to change some of my assumptions to evaluate other alternatives and propose a whole new class of currently non-existent investment with supercharged returns.

This post on tax efficiency is written as a follow up to the discussion on Lazy Man and Money related to Prosper Loans who posted in reference to Free Money Finance’s Criticism of Prosper as an investment. Personally, I have a laundry list of prerequisites to P2P lending.

Tax Basics: Income Versus Capital Gains

Interest income on loans such Prosper.com loans are taxed as income tax which is a higher rate than capital gains. You must pay income tax in the year you earn it, but it can be written off against valid expenses. Current income tax rates can be found at the IRS web site — my personal marginal rate is 29% which I will use for calculations below.

Capital gains taxes apply to both capital gains and stock dividends. The current US Capital Gains tax rate is 15%. More on the US capital gains tax can be found at Wikipedia. The most important aspect of capital gains, in addition to the lower rate than income tax, is that capital gains (except for dividends) can be differed. You only must pay the capital gains tax when the gain is realized. Additionally, this gain can be written off against other capital losses.

The Investments for Comparison Purposes

For comparison, I will use three real investments and one entirely fictitious investment to measure the tax impact on various returns.

1. I will use the S&P 500 and the actual returns from the last 20 years as a non tax protected investment.
2. I will use the same actual S&P 500 data with the investment going into a tax protected Roth IRA.
3. Prosper.com lenders often quote a 12% return as possible so I am going to take a huge flying leap and extrapolate that over 20 years to compare with the other options. The returns on this investment are taxable as income.
4. Finally, I will invent a new investment which does not exist — the Prosper.com Roth IRA. It is a tax protected investment using the same extrapolated 12% return across 20 years.

Which is the best investment?

After taking into account taxes and the below listed assumptions, which investment offers the best return? Before you answer, remember that the S&P 500 between sock price apprication and dividends gained an average of 13.44% per year and the Prosper extrapolated data earned 12% per year. The best investments at the end of the time period, when investing $1,000 at the beginning of each year, were:

1. The best was the Prosper Roth IRA. No income taxes on a Prosper.com account with a steady compounded return of 12% earns a total ending investment of over $64K. Any P2P companies listening? This might make a fantastic investment opportunity.
   
2. The S&P 500 as a Roth IRA was the second best investment with a total final balance of over $60K.
3. The S&P 500 as a taxable investment finished with a balance of just over $58K
4. The worst investment by far is the P2P loan portfolio which only ended the period at just over $44K.

Why is the S&P 500 in the Roth IRA only just slightly better than the non-Roth version? We have not sold the investment yet and selling will trigger capital gains on the non-Roth IRA investment. The Roth IRA will incur no capital gains on the appreciation, but the non-Roth would be responsible for $5,700 in capital gains taxes if we sold the entire position. Even after liquidating the taxable position, the S&P 500 investment would be worth over $52K which is $8K more than the Prosper loans. That is the power of deferring taxes!

Why did Prosper without income tax appear on top despite having the lower average return? The S&P 500 was effected greatly by volatility. Real investments are not measured in average returns because averages smooth out the lumps. Geometric returns show the real returns and include the volatility just like this actual S&P 500 data did. I’ll explain volatility and geometric returns in another article in the near future.

Graph of the data

A picture shows the entire four investment comparison. Click to see in larger size.

Show me the data

If you want to look at my actual data and or modify it to meet your personal circumstances, you can download my XLS file. There are six tabs:

1. The first tab “Summary” allows you to make certain assumption changes for analysis purposes and displays the results in both the graph and the summary table. You may change the initial investment, the annual percent increase in the investment, your marginal tax rate, and the capital gains tax rate. I also allow you to change the annual return on your Prosper loans. (Note that I did not program a control to stop the Roth IRAs from exceeding the maximum annual contribution.)
2. “S&P 500″ shows the actual S&P 500 returns for a non tax protected investment.
3. “S&P 500 Roth” shows the same S&P500 data with tax protection on the dividends.
4. “P2P Loan” shows the return on Prosper loans after tax.
5. “P2P Loan Roth” shows what would happen if you could make that same return on your Prosper loans, but protect the interest from income taxes.
6. “S&P Randomized” I added for fun. You can reorder the annual S&P 500 returns at random by activating the random function and the resorting the first few (colored) columns of the charts. It is amazing what the impact of the order of your returns can have on your final ending balance. The power of volatility!

Feel free to download it and play with the spreadsheet. (If you reuse it or use it to post some analysis in your blog, please credit me with a link to this post because it took several hours to create and double check.)

Conclusion: Taxes Do Matter for Return on Investment

In this simple analysis, I hope that I have convinced you that taxes do matter to your return on investment. Volatility can also impact your returns and I will detail that more later. Finally, please max out your Roth IRA before investing in P2P loans. Your final result balance will most likely reflect the difference by deferring capital gains taxes and avoiding income taxes.

Please comment with your thoughts on this analysis of the tax effects on investments.

Assumptions in the Analysis

This was a quick analysis that would not have been reasonably possible without a certain number of assumptions that simplified showing the impact of taxes on investments.

1. Current tax rates apply across the entire period.
2. No transaction costs.
3. Prosper.com return rate is unchanging across a large period of time which is a significant extrapolation.
4. All income and dividends earned over the course of a year were reinvested at the start of the next year.
5. All dividends and interest are reinvested.
6. Inflation was ignored.
7. No capital gains were triggered by stock sales throughout the period.
8. I obviously completely invented the Prosper Roth IRA. I just wanted to show how no volatility can increase your return on investment.
9. No defaulted loans were written of against the returns on the Prosper loans.

UPDATE: March 31st, 2009 — Announcement: Lending Club IRA is now available. This is tremendous news since my example above shows that a P2P Lending account that is tax protected is likely to be your highest performing investment.

roth ira, investment, money, prosper, p2p lending, taxes, capital gains, income, roi

Disclaimer: Consult a tax adviser and a financial planner before taking any action based upon this article. I do not know your situation, so this information may not apply to you.

Technorati Tags: roth ira, investment, money, prosper, p2p lending, taxes, capital gains, income, roi

Bookmark: