Virginity, Capital Gains and Safecredit Review

After a fairly long  gap, I am back with weekly links. In the past I used to call this – “Interesting Reads” but that got a bit boring, so now I am going to pick up a few words from the posts and use them for a title. That should spice it up a little.

Let me start off by pointing you towards this story that Weakonomics picked up about a Kiwi girl selling her virginity to pay for college. The final price for it – 30,000 US Dollars!

Bad Money Advice included this story in his February round up, and also pointed out an interesting comment by Cosmo who wondered if this would be taxed as capital gain or income, had it been legal in the US?

Not to get too carried away by all this, let me draw your attention now to some posts that are more in line with the theme of this blog:

Ask Mr. Credit Card does a Review

Digital Inspiration tells us how to get an exporter code for PayPal in India

The Big Picture takes an in depth look at the cyclically adjusted S&P 500 P/E Ratio

The Digerati Life tells us how cash only living can work

The Financial Samurai tells us a story about his friend who makes a lot of money but is not pursuing his dreams. I think a lot of people will be able to relate to this story. I actually had a post in drafts based on this but never got to finishing it. Sometime in the coming week I think.

Indian Thoughts wonders about Money vis-a-vis happiness – this and the post above are similar in nature, though both worth a read on their own.

Ajay Shah takes a look at some interesting features of the budget – mainly on regulatory co-ordination, financial reform and stability.

That’s it for this edition, I’ll be more regular with the links now that I am back and slowly getting back in the daily routine.

Personal Income Tax to go down after the budget

The Indian budget was positively received by most people today, and it has got a bit of good news for people who pay income tax.

The tax slabs have changed, and it translates into a Rs.50,000 savings for incomes up to Rs. 8 lakhs. Any amount over that will continue to be taxed at the earlier rate.

The new slab is as follows:

Income up to 1.6 lakhs: 0

From 1.6 to 5 lakhs: 10%

5 to 8 lakhs: 20%

Above 8 lakhs: 30%

This is a welcome change and if you compare it with the earlier slab – someone earning 8 lakhs will save Rs.50,000. This is of course a simplification, as it does not take into account the deductions you get from investments, EMI payments or other things like the LTA tax or HRA tax for example.

I feel happy to be able to write about this good news especially because I recently had a post an another bit of good news for Indian savers.

The bad news is that fuel prices will go up a bit, but in the larger scheme of things deregulation of fuel prices is a good thing for the Indian economy.

Retirement saving options for early retirement

You did your math.  You know how much you need to save for retirement.  Now what?  Do you just keep all your savings in a box under your mattress?  What about in the freezer?  A savings account at the bank?  None of these let your money work for you while you save it.  Let’s go over a few popular retirement saving options.  After we do, we’ll talk about how early withdrawal affects your savings.  Tax deferred savings options include:

  • 401(s)s at work
  • Annuities
  • IRAs

401(k)s are employer provided retirement savings plans.

  • The employee decides how much to contribute a month.
  • The employee gets to choose what to invest in from a list of mutual funds.
  • Contributions are put into the account before they are taxed.  Building interest is not taxed.  All withdrawals are taxed.  If the person lowers their tax bracket at retirement, the savings here can be great.
  • Company matching provides financial benefits to employees.  The maximum amount a company can pay is six percent the employee’s annual salary.
  • The maximum amount a person can contribute to their 401(k) is $16,500.  If an employee is over 50 ½, they can contribute an additional $5,500 annually.

Annuities are insurance contracts people buy from insurance companies.  By agreeing to pay a set amount of money up front, the owner receives money back after a set time.

  • Annuities are not normally good retirement investments unless a person has maxed out other options and wants to save more money tax deferred.
  • Annuities have many more up front fees than 401(k)s.  To take your money out before a minimum period (usually from three to five years), you must forfeit a surrender fee.  This fee is typically between 5% and 7%.  In addition, you must pay the 10% early withdrawal penalty to the IRS.
  • Payments are taxed first.  Contributions are not made pre-tax.  Earnings are tax deferred but are taxed as ordinary income when distributed.  This is a higher rate than the capital gains rate used for 401(k)s.

IRAs are self-directed retirement savings accounts.  There are eleven types.  Some are done through work.  The two most common ones are the traditional IRA and the Roth IRA.

  • With the traditional IRA, the amount contributed is tax exempt but everything is taxed when distributed.
  • With the Roth IRA, money is contributed after a person has paid his or her taxes on it.  Then, when the money is distributed, it is tax-free.  This makes sense if you think you will be in a higher tax bracket when you retire than the bracket you’re in now.  Oh, we can all hope, can’t we?
  • As long as you are younger than 70 ½ and you are earning money, you can start an IRA.
  • You can contribute $5,000 a year to your IRA.  If you are over 50 years old, you can contribute another $1,000 a year.  You can have both types of IRAs open (traditional and Roth).  Your total contribution in one year is still $5,000 or $6,000 (for those over 50).

If you are deciding to retire early, you might worry about what the IRS thinks.  After all, they don’t think you should retire before you turn 59 ½.  If you do, you would have to pay an early distribution penalty.  This is a 10% fee paid to the IRS on withdrawn money.  The penalty is supposed to help people keep their retirement money in their retirement savings accounts until they need them.

Here is the lowdown on that early distribution fee.

  • Not all early withdrawals face an early distribution penalty.  A person can convince the IRS they need to make a hardship withdrawal.  In this case, he or she will not pay the 10% early withdrawal fee.  The IRS usually accepts the following reasons for approved early withdrawal of retirement savings:  medical and funeral expenses, college tuition, to purchase, repair, or keep from losing his or her main home.
  • Tax law under 72(t)(2)(A)(IV) lets people start early withdrawal of their retirement savings without being penalized with that 10% fee.  This is the golden key for anybody contemplating early retirement.
  • As long you take out equal periodic withdrawals made during the rest of your life, you do not pay the early withdrawal fee.
  • Figuring out the right amount to take out is complicated.  The IRS accepts three ways to figure out how much you should start taking out.  These methods are the life expectancy method, the amortization method, and the annuity method.

A lot of paperwork is involved as well.  You have to use the same method to withdraw the money for five years or until you reach 59 ½, (whichever one happens last).

No entry loads hurting sales of mutual funds

SEBI (the market regulator in India) banned mutual fund entry loads last August, and I read an interesting piece in WSJ about its possible ramifications today.

Mutual Fund entry loads were expressed as a percentage, and were deducted from the money you invested in the mutual fund. It was used to pay commission to the distributor (mutual fund agent, insurance agent, broker, financial planner, bank agents etc.) who sold you the fund.

Example: Entry load of a fund is 2% and you invest 10,000 in it, – 200 bucks were deducted and given to the distributor.

SEBI put an end to it last August stating that if intermediaries want to charge you a commission (which is what this really was) – they should charge it directly to you instead of having that deducted from the amount you invested.

This makes the whole thing a lot more transparent as people understand that they are paying a certain percentage to the guy who is selling them this stuff, as opposed to some load that they were paying to the mutual fund.

This was a significant step as it takes away the big incentive from distributors who were pushing such funds. Now, they had to ask a fee for their advice from the investors, which didn’t go down too well with them. It also makes the investors a lot more aware of where their money is actually going.

The WSJ reports that this had very significant impact on mutual fund sales:

Unwilling to ask for money directly from investors, financial advisers, banks and even the post office have stopped pushing most mutual funds. All told, more than one million advisers have stopped peddling the funds for now. “The distributors are angry” about having to ask for fees, so they are not pushing mutual funds, said A.P. Kurian, chairman of the Association of Mutual Funds in India, an industry group. “This changeover is certainly affecting us.”

While I am not too convinced about the 1 million number; I think there has been a huge impact to the industry in terms of pushing such funds.

The story goes on to state that in a lot of cases the money that was meant to be invested in mutual funds finds its way into insurance schemes and fixed deposit schemes. It’s not that people find insurance more attractive, just that insurance has not made the same switch yet, and probably distributors who were pushing mutual funds earlier are now busy pushing insurance products. I think the regulators should make insurance companies to follow this model as well.

I think this move is good for investors because it makes costs transparent to them, and more importantly takes away a big incentive from agents who weren’t always keeping investor’s best interests in their mind. In fact, if you go around reading forums / comments and asking people about mutual funds they own, – you will be surprised to hear how many of them have in excess of 30 funds! I am sure some serious hard – selling was involved in such cases.

If retail interest is waning in mutual funds, then funds need to come up with lower cost funds, which perform over the long run, not lament about a positive change.

This is a great regulation by SEBI and I hope it doesn’t go away because of lobbying or any other pressure. I’d be interested to hear any reader stories if this change has personally affected you, so please do leave a comment.

Some good news for savers

Although a few days old; I missed this story somehow. Nevertheless, there is some bit of good news for Indians who have money in a savings account.

For some twisted reason, banks used to take the minimum balance of your account between the 10th and last day of the month, and calculated interest on that. So, if you had a low balance on one day but a decent amount for the rest of the month – your interest would still be calculated based on the lowest balance.

Example: You have 40,000 from Feb 1st to 25th, but on the 26th, you pay off your car and housing loan EMI, due to which your balance comes down to just 5,000.

The bank will pay you interest for the whole month of February only on Rs. 5,000.

This is pretty unfair, and it is easy to see how this benefits banks.

The RBI has now asked banks to pay interest to savings account holders on a daily basis. This will be effective from the 1st of April 2010, and will ensure that you get money on whatever is in your account, and not just the minimum balance.

This will of course dent the profits of the banks by a bit, – Bank of Baroda (BoB) expects their net interest margin (NIM) to decline by 0.12%, but that is a small price to pay for fairness.

If you are interested in bank savings in a bank, do check out my page on bank interest rates in India.

Photo Credit: Alan Cleaver

Overpriced IPOs

I am really glad to see that most new IPOs coming in the Indian market have really low retail participation. I am happy about that because every IPO has been very aggressively priced of late, and in my opinion there aren’t many good deals for the investing public. In fact, I can’t remember the last IPO that was priced decently.

This is true of private as well as government companies. The just concluded Rural Electrification Corporation (REC) FPO, and the NTPC FPO — both got lukewarm response from retail investors. In fact, it looks like the government has been egging on public sector banks and insurance companies to pick up the slack.

That’s why on most government IPO / FPO subscription numbers – you see low retail participation, but relatively higher institutional participation.

The just concluded Rural Electrification Corporation (REC) FPO was subscribed 0.22 times in the retail segment and 5.51 times in the qualified institutional buyer (QIB) segment.

Here is what the Business Standard had to say about this:

People familiar with the development said state-run Life Insurance Corporation (LIC) put in bids worth Rs 3,000 crore at Rs 205 per share. Source said public sector banks bids for shares worth Rs 1,200 crore, of which Rs 500 crore was bid by State Bank of India and Rs 300 crore by Canara Bank. The highest bid came in at Rs 215, for 214 million shares. Many mutual funds and foreign institutional investors (FIIs) are also in the fray.

Marketmen, however, are not convinced. “Last-day negotiations at the highest level saw the issue being oversubscribed,” said a banker on condition of anonymity. “As with the NTPC FPO, state-owned entities had to chip in for REC. It is anybody’s guess what will happen to NMDC,” he added.

In fact, LIC acquired 2.5% stake in the NTPC FPO that was recently concluded. That offer was priced at just a 5% discount to the market price. No wonder, people were not interested.

I don’t understand what they are trying to achieve here. This is like taking money from one pocket and putting it in another. These are decent companies, and if their offer is priced right, – the public will be interested. It will also act as a deterrent to private companies who don’t have much by the way of a track record, and come out with lofty prices on their offers.

I have a feeling we will see days when these offers are priced right, because state owned banks and LIC can’t keep doing this forever, but who knows when that will happen.

Photo Credit: Cosmic Kitty

Program trading picking up in India

The Business Standard has a story about program / algorithmic / high frequency trading gathering steam that caught my eye today.

The story reminded me of the High Frequency Trading uproar in the US a few months ago, and I think India is going down the same path as far as this type of trading is concerned.

Program or algorithmic trading is automated trading that is done by computers without any manual intervention, and is done at high speeds.

From Business Standard:

Algorithmic trading uses strategies that exploit short-lived market opportunities and depend highly on execution speed. Essentially, set software programmes decide when, how and where to trade, without the need for human intervention.

The story talks about algorithmic trading gaining currency in the last year and top brokers expecting it to continue momentum going forward.

A big part (or possibly all of it?) of program trading is arbitrage, buying and selling at high speeds and taking advantage of the price mismatch that exists in the market. As US Investment banks have shown, this is highly profitable too, so there is every reason to believe that Indian brokers are going to invest and scale up quite a bit.

In fact, NSE has already signed with 60 members to allow them to co-locate their servers close to the exchange servers.

From BS:

NSE has already signed with 60 members for a co-location facility, whereby they can place their trading servers close to the exchange’s engine for Rs 22.5 lakh on a first-come-first-served basis. Co-location saves crucial milliseconds from the time it takes to place an order and its receipt at the other end. The broker with his server next to the exchange engine gets a price feed that is updated every three-four milliseconds, while a broker at a remote place will get this feed updated every 30-40 milliseconds. SMC, which had applied for four rack spaces with NSE, was allotted two. It would be allotted the other two soon. Each rack can easily handle two servers, each of which can handle orders worth Rs 200 crore.

So, basically, some market participants will have an advantage in terms of being able to execute faster than everyone else and getting price information faster than everyone else. This is great for the broker who will make money out of this edge, and for the stock exchange which will make commissions on increased volumes.

To you and me, it is most probably a disadvantage, and when I first heard about this concept, – I wondered how is this even legal. But, that’s just how it is. At least until the next scam or market meltdown anyway.

Economy and your finances carnival Feb 21st 2010

Welcome to the February 21, 2010 edition of OneMint – Economy and your Finances. presents Are Public Wi-Fi Spots Safe? posted at SpendOnLife, saying, “A bit of information on why you should be careful when using wi-fi in public places. Thieves can access information to be used in stealing your identity.”

Billeater presents Six Ways to Save on Baby Expenses posted at Billeater.

Heather Sanders presents Definitive Short Dollar ETF Guide: Inverse USD ETFs posted at ETFdb.

Dividend Tree presents Case of Dividend Growth in Emerging Economies posted at Dividend Tree, saying, “I view multinational companies are potential opportunities for dividend growth, hedge against dollar fluctuations, and proxy for emerging markets.”

PT presents Tax Deductions Commonly Overlooked posted at Prime Time Money.

Peak Personal Finance presents Tax Time: Home Related Tax Breaks posted at Peak Personal Finance, saying, “Don’t overlook these tax benefits of home ownership.” Continue reading “Economy and your finances carnival Feb 21st 2010”

Using annuities for retirement

An annuity is a contract between insurance companies and people arranging for retirement.  The insurance company agrees to pay you money in the future for the money you give them now.  In theory, an annuity would make sense because:

  • Annuities offer guaranteed income in the future (although surprisingly, the definition of guaranteed is malleable here).
  • Annuities are tax deferred retirement investments.  You pay taxes first for money you put into an annuity.  The capital gains grow tax-free until you start withdrawing them.  When you receive your annuity benefits, you will pay taxes on capital gains as well.

So far, annuities sound good.  The following problems, however, exist with annuities:

  • Annuities lock up money for a minimum period (usually five years).  If you want your money, you will need to pay surrender fees.  Surrender fees are stiff.  They range anywhere from 5% to 7%.  This is in addition to the federal 10% early withdrawal tax.  This tax occurs when money is taken of retirement funds before the owner is 59 ½ years old.
  • Annuities often offer lower returns than other retirement options.
  • Contributions are not pre-tax as they are for 401ks.  The earnings are, however, tax deferred.
  • The IRS taxes capital gains earned in an annuity as ordinary income.  Ordinary income taxation rates are higher capital gains rates.
  • Annuities usually have many more fees than other retirement options.
  • Annuities are not the best for estate planning.  If you die before using your annuity, beneficiaries must pay taxes on the capital gains.  Not so with mutual funds.

Why consider an annuity at all?  Annuities make sense in the following situations:

  • You have maxed out 401k and IRA annual contributions.  You still want to invest money into tax deferred investment options.
  • Annuities do not have a contribution limit.
  • You want to diversity your retirement plan.  Insurance sounds wonderful to pessimists.

When shopping for annuities, one size does not fit all.  Types of annuities include:

  • Fixed annuity meaning the interest rate for the invested money is fixed.  It does not change.  The money is usually invested in low-risk fixed income products like bonds.
  • Variable annuity meaning the interest rate for the invested money is variable.  This type of annuity can produce a higher or lower payout.  The payout depends on how well the investments do.  Variable annuities usually still have guaranteed minimum returns.
  • The equity-indexed annuity is an option that has been around for about ten years.  This annuity acts a variable annuity with a safety net when the market gets bad.

Payout schedule options include immediate payments and deferred payments.  Payments can last for the owner’s lifetime or for a set term.  Other options when purchasing annuities include:

  • Cost of living protection
  • Premium protection
  • Joint and survivor benefits

Annuities are only as good as the insurance company backing them.  Shop around before picking one.  Do not buy in a rash moment.  Make sure you know whom you are dealing with.

Federal law allows for tax-free exchanges between annuities.  This can happen if you decide you invested your money in a poor annuity.  You would like to move your money to a different annuity.  Normally, if you take money out of an annuity before retirement, you face the 10% early distribution penalty tax.  However, if you move the money into another annuity, US tax code 1035 allows for tax-free exchanges.