Basics of Roth IRA

Basics of Roth IRA

The Individual Retirement Arrangement (IRA) or what is generally known as the Individual Retirement Account is the personal retirement savings plan of an individual, with taxable income that includes salaries, wages, tips, fees, bonuses, commissions, taxable alimony and separate maintenance payments. The Roth IRA is also an Individual Retirement Account which provides growth without you, the account holder, having to pay any taxes.

The Roth IRA account provides you with better tax facilities which are simple and effective. This is because all your contributions into this account have already been taxed. It also means that you have to pay all your taxes before making any contribution to Roth IRA. Once this is done and the money is invested in your Roth IRA account you have not to pay any taxes on any withdrawals and there is no need for these withdrawals to be reported at any time. Your gross adjusted income (AGI) during retirement thus remains unaffected. However, the only drawback of this account is that you might have to pay a higher tax, as it is paid during your working period rather than after your retirement.

This account can be opened through any provider who provides normal investment accounts including stockbrokers and mutual funds. In case you meet the criteria in a given year for opening a Roth IRA account, you will have to do so by the following April 15. The eligibility criteria are of course based on your age but your income level and filing status. There is no compulsory requirement for distribution.

It is an account created basically for working people so that they can save for their retirement. Here, the contributions have to be made from salary and not from any other source of income. Therefore lazy kids and wealthy people generally do not make the grade. However, the limits and rules change every year.

There are some withdrawals in Roth IRA such as:

a) The withdrawals made to your beneficiary or to your estate agent after your death

b) The one made on or after you become 59 1/2 years old

c) When according to the IRS code, you become disabled

d) if used to pay qualified first time home buyer expense.

If the withdrawals are made for any one of the above mentioned purposed and within the five year tax period the distribution (that is the withdrawals made from additional contributions, earnings or conversions) will not be qualified for tax exemption. The qualified withdrawals are those which are previously taxed before the contribution stage and are made after the five year tax period. The tax year will begin on the day when the tax payer first contributed to the Roth IRA.

The tax breaks in Roth IRA is different in as much as in Roth IRA the savings are tax exempt while in others the tax is deferred and has to be paid at a later date. The difference is that while the traditional IRA allows you to increase your wealth like Roth IRA, it also makes you pay for the profits at a later date which is what the Roth IRA does not do. It is better to pay the government while working than after your retirement.

Traditional IRA – An overview

As the name suggests, Traditional IRA is one of the oldest Individual Retirement Account in United States. IRA accounts are primarily savings account; the benefits of which are reaped in one’s old age. IRA accounts are used to accumulate money with a government sponsored agency or some other reliable private agency. For example you can open a Traditional IRA account with a bank. The bank may allow you to invest your IRA account contributions in instruments like bonds and CDs (Certificate of Deposit). Thus your contribution will start earning interest thereby adding a sizeable amount to your savings. Similarly, if you open a Traditional IRA account with a brokerage firm, then you can invest into securities, equity funds, debt funds, etc.

One of the main advantages of a Traditional IRA is its tax free contributions. This means that as far as the money lies in your Traditional IRA account, it will not attract tax. This includes your contributions to the account. Since you can invest your contributions into fixed and variable return instruments, you are bound to mostly make some income on your investment. Even these additions to the account are not taxable.

However, the catch lies in withdrawal. All withdrawals from a Traditional IRA account are tax liable. Applicable federal tax rates apply when you withdraw money. This is exact opposite to a Roth IRA where contributions are tax liable but not any withdrawals.

Contributions to a Traditional IRA account are limited. For example, if you are 50 or above the age of 50, then for the year 2006 you can maximum add $5,000 to a Traditional IRA account. So say, if the federal tax rate applicable to you is @15% then you will save a tax of $750. However, if you are below the age of 49, then maximum contribution for 2006 is $4,000. At rate of 15%, you will then save only $600.

Another major rider to Traditional type of IRA account is the income limits. On an approximate scale, if your gross income exceeds $80,000, then all your contributions are taxable. That means you loose the biggest advantage of Traditional IRA account. On the other hand, if your gross income is approximately below $40,000, then your entire contributions for the year (provided they are below the maximum contribution allowed) are tax free. The exact gross income threshold limits depends upon how you file your income tax return. Singles have least income threshold and if you file “Married filing jointly” or similar, then income thresholds are higher.

So which IRA account is best for you? The answer lies in your foresight. If you think, that you will retire from professional life and your income will be very less in your old days, then Traditional IRA can be a good pick. But remember that, after age of 70 and a half, you cannot take or continue a Traditional IRA. A thoughtful selection can prove to be a big help at the time when you need it most.

Traditional IRA compared with Roth IRA

No wonder how healthy we might be but we all realize that one day we will grow old. Hence, we all know that we should plan our retirement such that we have sufficient money to support ourselves and our family in those last 2-3 decades of life. Most of us invest money in retirement plans like IRA. However, though there could be many common things among us there are also major differences in our income and lifestyle. Hence, an IRA which might be good for someone may not be the best fit for you. This article compares two of the most popular IRA plans; Traditional IRA and Roth IRA.

Age Eligibility

Traditional IRA can be taken by people only below the age of 70 and half years. So if you have already crossed this age threshold, then you should stop thinking of taking a Traditional IRA plan. Roth IRA however has no age limits.

Compensation criteria

In both Traditional and Roth IRA, to apply for one, you should be getting compensation. While calculating compensation, you can also include compensation received by your non-working spouse.

Contribution rule

Both the plans have similar rules pertaining to Contributions. In both your contributions, including that of your non-working spouse cannot exceed your combined compensation.

Income limits

Traditional IRA has no income limits. However, in Roth IRA for individual filers, income limit is set to $95,000. If you are filing jointly, then the combined income limit is $150,000.

Contribution limits

$4,000 or 100% of compensation (whichever is less) per person per year is the contribution limit in both the plans. If you are above the age of 50, then there is a provision of “catch – up’ that you can use to increase your contributions. Under this provision, you can make limited additional contribution. This “catch up” contribution is set as $1000 for 2006.

Tax Advantage & Disadvantage

In traditional IRA, you Contributions can be tax deductible. That means you can deduct the contribution from your taxable income and hence save tax. However, in case of Roth IRA, contribution is not tax deductible. But the growth of the corpus is not tax free in Traditional IRA. And it is tax free growth in Roth IRA.

Withdrawals

In Roth IRA, you can withdraw money anytime during the plan tenure. This is a great advantage as you get great assurance against future financial uncertainties. You can also withdraw anytime from a Traditional IRA. However, if the withdrawal is made before the age of 59 and half, you have to pay penalty. Penalty can be avoided only under circumstances. For example, if you are buying a house for the first time and if you satisfy certain other conditions, then you can escape getting penalized. Similarly, if you have to spend high on medical services or educational services, then you can do a penalty free withdrawal from your Traditional IRA. However, in this case your medical expense should be more then 7.5% of your annual income. There are a few more such clauses.

Both the IRA plans has their unique pros and cons. You would need to do an honest introspection and decide which plan to opt for. A wise choice can prove to be your backbone for the future.

Simple IRA – Key Terms

IRA or the Individual Retirement Account provides double benefits to the customer. In the first instance it provides Compound Interest and the additional benefit is that there is no tax on this income. This mode of saving is really good if you have the money and can afford to keep it in the account for a longer period. The benefit of compound interest, without the additional burden of tax on this amount, is a powerful incentive to contribute in the Individual Retirement Account or IRA as it is commonly known.

It is better to know some of the terms and what they mean to you as an Individual Retirement Account holder.

1. Annual Contribution Limits.

There are limits to the amount of money that you can contribute annually in any type of IRA. Roth IRA limits the contributions to a maximum yearly amount which excludes the traditional IRA contributions of the taxpayer. However contributions in education IRA can be made in addition to the annual limits that are imposed on the traditional as well as Roth IRA contributors.

2. Adjusted Gross Income or AGI.

It relates to the entire amount you collected or your total income minus the adjustments made towards moving expenses, deductible retirement plan contributions and any other expense which has been paid through this account.

3. Contributions.

The term does not refer to your original contribution to the IRA account. This is also not a reference to the money, usually called the principal amount that you deposit into your account. It is the ‘conversions’ to the Roth IRA that are termed by the IRS as ‘qualified rollover contributions’. These amounts are treated as additional contributions when IRS regulations are applied. The distribution rules for ‘qualified rollover contributions’ however differ from those of regular contributions.

4. Distributions or Withdrawals.

The term refers to the amount taken from your IRA account. Distributions usually consist of additional contributions, earnings or conversions.

5. Education IRA (EIRA) refers to the account created to help fund education. It has since been renamed as Coverdell Education Savings Account.

6. Group IRA or Employer and Employee Association Trust Account. This refers to the IRA account set up by employers, employee associations for members and unions.

7. Individual Retirement Annuity.

This refers to the IRA account set up with the participation of a life insurance company by having a special annuity contract.

8. Inherited IRA

Inherited IRA refers to the deceased IRA holder’s account which in the absence of a spouse, benefits some other individual. Here the contributors are not allowed a tax deduction according to the Internal Revenue Code.

9. Rollover (Conduit) IRA

This refers to the account operated to get distribution from a defined contribution, benefit or retirement plan. These distributions are not bound by any contribution limits.

10. Individual Retirement Account

This refers to an account with a broker, mutual fund or bank where the contributions can be invested in various types of securities such as bonds, stocks and the money market.

Introduction to Education IRA

Education IRA is an account created by the Taxpayer Relief Act 1997. It is meant to be used for meeting the educational expenses of the student. The expenses on tuition, books, supplies and items required for enrolment or attendance at the selected institutions, also the expenses of boarding and lodging as determined by the institution or the actual amount charged by the eligible institution at the houses run by them including any other educational expenses incurred for students with special needs are exempt from taxes under this Act. All the amounts contributed into this account are also allowed to grow tax free by the government. However, there are definite limits to the amount of annual contribution that can be made into this account.

 

The main purpose of this account is to save enough money to meet part or whole of the college expenses. You can generally invest up to $500 per year. It can be less as the contribution depends on your income.  The money in the education IRA can be invested in just about any financial instrument for better returns. However, this money is controlled by the college going child and can be spent only on his or her education. In case the money from the education IRA is not used by you it can be transferred to someone else. It maybe a relative or someone you know, who can use this money for education.

 

All withdrawals from the education IRA do not fall under the taxable category but the contributions to this do and are taxed at around 10% or as the case maybe at the time. The Education IRA where you can save $500 per annum can be a good choice for all those who qualify to invest under this scheme but the amount is far from sufficient to meet the child’s complete educational expenses.  Therefore it is necessary to have an additional plan for meeting the educational expenses of your child

 

You will be exempt from paying the additional 10% tax for the year in case you pay the qualified educational expenses for yourself, your spouse or you/your spouse’s children or grandchildren.  It is however necessary to enrol the student in any educational institution like any college, vocational school, university or  others which is recognised and allowed to take part in student aid programmes administered by Department of Education. Some of these eligible institutions also can be found outside the U.S.  Almost all accredited public institutes, postsecondary, non-profit or private are generally eligible.

 

Form 1099-R which you receive from the tax authorities indicates the taxable amount of your distribution (withdrawal from additional contributions, earnings or roll overs).  Under this IRA scheme the taxpayers with gross incomes which are under $ 150,000 to $160,000 for joint and $95,000 to $110,000 for single fliers, are allowed to make contributions to the education of any student of 18 and under.

IRA

IRA stands for Individual Retirement Account and it allows individuals to make contributions towards an account in a tax deferred manner.

What this means is that individuals will not be taxed on the amount that they deposit in an IRA or the income generated from it till the time that they withdraw the money from their IRA. There is a certain maximum limit of the contribution and age restrictions for the individual who can contribute to an IRA.

Why the market falls faster than it rises?

 

Almost everyone who has been in the market must have noticed that shares fall faster than they rise.  This article looks at a couple of reasons because of which this happens. 

One reason why this happens is because of traders buying shares on margin money. This happens as follows. Suppose you have shares worth Rs. 1 lakh, on these shares your broker will allow you to take positions of say up to Rs. 40000. What this simply means is that you can buy and sell shares worth Rs.40000 without actually having to cough up this amount. This is called playing on margin money. In the above example the margin is 40%, which means that you can play up to 40% of the shares that you own. Every time the margin decreases below 40% you have to either square off the position or you have to keep extra cash with your broker. Now assume that you have also entered into such a trade where you had shares of say HLL worth Rs.1 lakh and you have bought shares of Infosys for Rs.40000 with the margin hoping to sell them off later in the day and make a quick buck. Unfortunately for you however the market falls and the value of HLL now remains only Rs.90000 whereas you have bought Infosys worth Rs.40000. To maintain the margin of 40% your broker calls you to pay up additional margin money (called margin call in market parlance). You decide that its not worth it and sell the Infosys that you have, further creating downward pressure and lowering the price of Infosys. If you look at the bigger picture and see the market as a whole there certainly will be another person who was holding Infosys worth Rs. 1 lakh and HLL worth Rs.4000, because of your decision this person would need to sell his HLL now. This is a vicious cycle in which many traders will now get trapped and what started off as a correction would result in a big fall. This is one of the prime factors why markets fall off sharply in a single day, the fall being anywhere close to 300 to 800 points on the BSE. 

Another reason why the market falls rather sharply is what is known as “Panic Selling”. What this means is that small and new investors in the market see that the market is falling and they think that there is no end to the fall. Often these investors enter the market with the lure to make big money and know little about what companies they are buying and have little confidence in their investment decisions. Such investors tend to sell all of their holdings in such falls and bail out of the markets. In the process they tend to drive the prices of the shares that they hold further down and end up pushing the prices abysmally low. 

The above two reasons are quite common and can be witnessed in every big fall that the market has. Its for you to understand these reasons and the next time you enter a trade be aware of such reasons and play the market carefully. Anyone who has been in the market will tell you that it is almost impossible to avoid such losses. So maybe you will lose money on such transactions as well. Considering the way the market has risen these days it is probable that the situation confronts you in the near future. You must not completely shun away from the market after such a situation but must understand the reasons, learn from them and not repeat the mistake. 

IPO Myths

There exist several myths about IPOs, which lure the investors into applying for each and every IPO that come in their way. The general perception is that IPOs are a fail-safe way to make money and that if one invests money in an IPO returns are guaranteed.

This is the greatest myth about IPOs. Many IPOs will result in losses for the investors, the prices of the same will go down because of several reasons like a weak company, over pricing, weak management or simply because the price fell along with the general markets. A look at the table below shows you how many IPOs have failed in the past.

A second myth about IPOs is that if one steers clear of the smaller companies and invests only in IPOs of well-known companies one will make guaranteed profits. This is also not true as we can see that a lot of well-known companies like HT Media, Provogue, OBC, Allahabad Bank, Jindal Polyfilms, T.V. Today Network are listed in the table below.

These are all big companies and chances are that most investors would have heard of them before the IPO. But still they figure in the list and the most likely reason is that the issue was over priced.

This is an important learning for all of us. Even our team got carried away and gave a good recommendation for Jet Airways, which was trading below the issue price some days back and made the same mistake. However we learnt from our mistake and investors who would have taken a hard look at our recommendation for Provogue would have avoided burning their fingers.
We will keep this article shorter than the average size of most of our other articles simply because we feel that these are two very very important things for investors to keep in mind and its best that these two points sink in and are internalized by all investors so that they can avoid burning their fingers in the stock market and especially with IPOs.

 

S.No. Name Price as on 27th Oct 2005 Issue Date Issue Price
1 HT Media Ltd. 427.35 04/08/2005 to 10/08/2005 Rs.530
2 Shri Ramrupai Balaji Steels Ltd. 17.3 08/07/2005 to 14/07/2005 Rs.22
3 Nectar Lifesciences Limited 199.35 22/06/2005 to 28/06/2005 Rs.240
4 Provogue (India) Ltd. 136.25 10/06/2005 to 16/06/2005 Rs.150
5 Jindal Poly Films Ltd. 289.9 09/06/2005 to 15/06/2005 Rs.360
6 Oriental Bank of Commerce 235.15 25/04/2005 to 29/04/2005 Rs. 250
7 Allahabad Bank 76.85 06/04/2005 to 12/04/2005 Rs.82
8 Jai Prakash Hydro-Power Ltd. 30.3 22/03/2005 to 29/03/2005 Rs. 32
9 Datamatics Technologies Ltd. 87.7 12/04/2004 to 19/04/2004 Rs. 110
10 Dishman Pharmaceuticals & Chemicals Ltd. 131.9 29/03/2004 to 07/04/2004 Rs. 175
       
11 T.V. Today Network Ltd. 76.9 18/12/2003 to 27/12/2003 Rs. 95
12 D-Link (India) Limited 126.75 20/2/2001 to 27/2/2001 Rs. 300
13 Creative Eye Limited 9.1 03/11/2000 to 09/11/2000 Rs. 50
14 Pritish Nandy Communications Limited 49.6 04/09/2000 to 11/09/2000 Rs. 155
15 MRO TEK Limited 70.65 04/09/2000 to 09/09/2000 Rs. 95
16 Shree Rama Multi Tech Limited 15.7 15/01/2000 to 21/01/2000 Rs. 120

Online Trading in Stocks

Online Trading is a recent phenomenon and many investors have started to open trading accounts with companies, which provide online trading facilities. 

If you have a computer with a decent Internet access online trading can ease a lot of your troubles, which you face with the traditional offline brokers. It is particularly useful for those people who regularly invest in IPOs. Anyone who has invested in an IPO will tell you how easy and convenient it is. 

One of the biggest problems faced in offline brokerages is that the IPO is opened for a very short period of time and very often investors are scrambling for application forms or making cheques or drafts in the name of the company for which the IPO is there. Very often these cheques / drafts have to be made for escrow accounts and the names are not very straightforward. Quite a few investors end up making mistakes in entering the names and although it seems like a silly small thing many investors end up losing the opportunity to invest because of this reason. This hassle is not at all present in online investment as you do not have to write cheques or drafts, just simply decide the number of shares that you want to buy and apply. The money is automatically transferred and there is no need to write any cheques. 

Another perpetual problem especially with those IPOs, which are in high demand, is that the application forms invariably finish by the time you get to your broker’s office and you have to again run around to get a copy of the same. This is a story, which is oft repeated at every popular IPO, and getting an online account is a good way to get rid of this problem as you do not have to worry about the form and can apply without one just by a few clicks. 

Whenever you log onto your account you get to see which are the IPOs which are open currently and therefore it becomes easy for you to keep a track of these IPOs and the likelihood of your missing investing in one “just because you didn’t know” decreases. 

Another problem that people who invest in IPOs face is the refund money (because of the difference in the shares applied for and shares allotted). Some investors have faced the problems of misplaced cheques or getting them after a long delay whereas in the online accounts you get this refund pretty quickly and your trip to deposit the cheque in the bank is also saved as your money is transferred automatically in the bank account that is linked to your trading account. 

These are some of the benefits that the author has experienced while using www.icicidirect.com The author has not used or does not recommend any other online account and is in no way related to www.icicidirect.com