Investing in peer-to-peer loans may earn you decent profits – at least that’s the hope, right? What happens at tax time, though? Does Uncle Sam want a portion of your proceeds?

Like any other investment, capital gains are taxed unless your investments fall in a specific category – tax-advantaged accounts, aka retirement funds.

Ordinary Income

The IRS considers the earnings you make on your peer-to-peer lending loan ordinary income. In other words, you add it to your current employment income to come up with your tax liability, so chances are you’ll owe money on the earnings.

Of course, the amount you owe varies based on your personal factors including your tax brackets and deductions. Typically, though, the income falls within the same category as your regular income. Let’s say for example you made $40,000 this year at your job. You also had peer-to-peer loans that earned you a 10% return on your $10,000 investment.

You’ll owe the IRS your portion of the taxes. Let’s say you are in the 20% tax bracket. You’d pay the IRS $200 of your earnings. You may also owe your state a portion of your earnings. Let’s say your state tax bracket is 4%. You’d owe another $40 to your state. That brings your earnings down from $1,000 to $760, reducing your rate of return.

Open an IRA

If you want to shield your earnings from the IRS and walk away with the full earnings in your pocket (or at least your account) consider an IRA peer-to-peer loan.

Not all platforms offer this option, so you may have to shop around. With the IRA you don’t have to claim your earnings on your taxes. Using the same example above, you’d walk away with the 10% earnings in your account and you wouldn’t have to claim the capital gains on your taxes.

There’s a catch. You can’t withdraw the earnings. They remain tax-advantaged or tax-deferred because they are in a retirement account. You can’t withdraw the funds until you’re 59 ½ or older. At that point, you can withdraw the funds and pay taxes on the earnings. Hopefully, when you’re in your retirement years, you’ll pay fewer taxes because you’ll be in a lower tax bracket.

Offsetting your tax liability with an IRA is a great way to keep more of the money you earn rather than giving a percentage of it over to Uncle Sam.

Not everyone is eligible for an IRA account and not all P2P platforms offer it. If you want to shield yourself from tax liabilities, keeping more of your earnings, shop around to find the platform that offers it and that you qualify for, keeping in mind that some platforms require you to open a regular account before qualifying for the IRA.

As always discuss your tax liabilities and tax questions with your tax advisor before starting a new investment account. Peer-to-peer lending is a great way to earn high rates of return, but knowing how it affects your tax liability will help you make the right choices.

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