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| Monday, May 28, 2007 |
| Who can contribute to an IRA? |
We are looking into the possibility of letting Jacqui stay at home as a housewife. However, we're concerned that if it will impact our plan to catch up on retirement savings. So I studied IRS Publication 590, Individual Retirement Arrangements and found the following excerpts:
Traditional IRA:
- You (or, if you file a joint return, your spouse) received taxable compensation during the year, and
You were not age 701/2 by the end of the year.
Roth IRA:
Generally, you can contribute to a Roth IRA if you have taxable compensation (defined later) and your modified AGI (defined later) is less than:
- $160,000 ($166,000 for 2007) for married filing jointly or qualifying widow(er),
- $10,000 for married filing separately and you lived with your spouse at any time during the year, and
- $110,000 ($114,000 for 2007) for single, head of household, or married filing separately and you did not live with your spouse at any time during the year.
Besides the age restriction for traditional IRA and the income restriction for Roth IRA, a person need to have taxable compensation to contribute to an IRA. The taxable compensation includes salaries, tips, bonuses, commissions, self-employment income, alimony and separate maintenance, nontaxable combat pay but does not include passive income derived from property and investment (Table 1-1, Page 9). However, a non-working spouse (aka a housewife) can contribute to either IRA with the same maximums given the working spouse qualifies for the above criteria (Refer to spousal IRA in the above document).
So the good news is that if Jacqui stay at home, both of us will be able to contribute to IRA though it's not necessarily Roth.Labels: IRA, personal finance, Retirement, Tax |
posted by Yannick @ 5:21 PM | Add to del.icio.us
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| Sunday, March 25, 2007 |
| What investments to hold in your IRA? |
I wrote a post to recommend Roth IRA earlier. Another article The Best Investments for Your IRA let me recall a class I took.
I took a PhD level tax class cross-listed in the finance department two years ago. I've forgotten most things learned in the class, since it's pretty theoretical. However, sometimes the professor discussed some very practical questions at the request of the students. Think finance or economics PhD students are all financially savvy? Some students didn't know what IRA was and asked this question to the professor.
There is no absolute answer. The common wisdom is to hold bonds and CDs in tax sheltered account since dividends and interests are usually not deferrable and taxed as ordinary income's higher marginal rate. On the other hand, a buy-and-hold strategy for stock investments could defer the capital gain from price appreciation almost forever, which is much more tax efficient (same effect as a 401K type of tax deferment without employer matching). As a famous example, Warren Buffet argues that dividend is much worse to a shareholder than stock price appreciation, thus Berkshire Hathaway does not distribute any dividends despite being one the most profitable companies in the world.
However, some people argue that stocks should be kept in tax sheltered account because the expected annualized return for stocks is much higher than savings and bonds over the long term (>20 years). Given same contributions, stocks grow much faster. Therefore, this strategy gives more assets the tax benefit. This strategy makes even better sense for Roth IRA, since its future earning is tax-free, not tax deferred.
Assuming you have a portfolio of $10,000 bonds and $10,000 stocks, with a marginal tax bracket of 33% (including both Federal and state income tax). The long term annualized return of bonds and stocks are 6% and 9% respectively. Compare strategy 1 of holding bonds in Roth, and stocks in regular account, and strategy 2 the opposite, what's the outcome in 30 years? To simplify, let's assume a passive stock investment using a highly tax-efficient ETF on market index, with 0.5% taxed on capital gain and dividends annually. Capital gains and dividends are reinvested.
Strategy 1 = 10000*1.06^30+10000*((1.085^30-1)*0.67+1) = 57.4K+80.7K=138.1K
Strategy 2 = 10000*1.09^30+10000*1.04^30 = 132.6K+32.4K = 165.1K
So keeping stocks in Roth IRA will win (Strategy 2). There are a few caveats on this conclusion:
This conclusion relies upon the 3% difference in annualized return between stocks and bonds. If as some authors have argued in their books that the future rates of return of stocks and bonds are about the same at 6-7%, you should hold bonds in Roth, and use a buy-and-hold strategy to defer taxes on capital gains from stock price appreciations.
The stock investment strategy is also critical. If we assume that the difference in the rates of return of the two are not that large, however, if you really trade your stocks frequently, then it's still advantageous to keep your stocks in Roth.
I also learned both in class and from my experience how tax policy exerted distortion in your trading decision. I had hold stocks just to get the long-term capital-gain tax rate even though the market condition for that stock had turned south. If you want pure undistorted trading decision for yourself, hold stocks in Roth. On the other hand, you lose the leverage on claiming loss on your trades as well.
I hold stocks in my Roth and have done some trading. I really love the tax-free capital gains. Roth IRA is really a very powerful tool for us to catch up.
I only discussed bonds versus stocks. People have used IRA holding to buy futures, options, land contracts etc., which enable them to have larger leverage and gain larger tax-free earnings. However, if you are old enough to believe no free lunch, you will probably want to think about the risk carefully before shooting for the "big gain"?.
Any questions and comments?Labels: Asset Allocation, Investment, IRA, personal finance, Portfolio, Retirement, Tax |
| posted by Yannick @ 4:31 PM | Add to del.icio.us
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| Friday, March 23, 2007 |
| Win a free 2006 TaxCut Premium with e-file by sharing your tax filing experience |
Our dear readers:
Thank you for visiting our blog. Yannick and I shared our tax filing experience on various topics such as filing as a non-resident alien or resident alien, claiming tax treaty benefits after becoming a resident alien for international students, an unpleasant experience with encrypted pdf tax forms, contributing to a 2006 Roth IRA and most recently how to deal with incomes from two states as a double-income couple.
Now here is the fun part. Someone from TaxCut came across my last post and thought my sharing was good. He has kindly given me a free coupon code to download a copy of TaxCut Premium (Federal + State + efile) , retail value of $64.99. I have no use of it and will give it away to one lucky reader through a lottery.
Here is how to enter the lottery:
You can either
1. Comment on this post and leave your email and nickname to enter the lottery for one chance to win,
or better yet, 2. share your tax filing method (manual, TaxCut, Turbo Tax, Turbo Tax+Quicken, or TaxCut+MS Money like us) to double your chance to win,
or the best, 3. share with us your experience briefly on how well the approach works for three times your chance to win.
You can enter the lottery before Noon Sunday (03/25) PT and the winner will be announced by Sunday night.
How to decide the winner:
Each entry will be assigned to 1, 2 or 3 unique numbers sequentially starting from 0. I will use a random number generator to generate a winner from the above numbers.
We were really satisfied with the TaxCut interview process and how seamless it generated 1040, Schedule A, B, Ds after pulling data out of MS Money. We are curious about how well the other approaches work.
Questions and comments? Good luck!!!Labels: Bargain, federal tax, Freebie, income tax, state tax, Tax, TaxCut, Technology |
| posted by Jacqui @ 10:50 AM | Add to del.icio.us
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| Thursday, March 22, 2007 |
| Tax returns with incomes from two states, file jointly or separately? |
I finished our tax return last weekend, which was much more time-consuming than I had expected. For 2006, Jacqui and I need to file income taxes with two states because both us graduated and moved. Jacqui had income from her job in the current state, while my full year income was from the previous state.
Starting from Federal tax return, we needed 1040 because we had over $1,500.00 in interest and capital gains respectively, and a tax treaty benefit to claim. I used TaxCut to extract our financial transactions and categorized spending from our Microsoft Money account. It filled in 1040, lacking the tax treaty benefit; automatically produced Schedule B, D and schedule D-1 with short term capital gain and long term CG separated, which was very slick. I downloaded 1040 etc. and fill in the forms electronically in Acrobat Reader to claim a treaty benefit which TaxCut does not include. So the 1040 in TaxCut was not usable directly, but the Schedule B and D were. I knew what change I need to make on 1040, thus, I was able to reference the TaxCut 1040 often to make sure I wasn't missing any deductions. We did not have a mortgage to pay, therefore Schedule A was empty.
Getting into State tax returns, I was first surprised to see the states claim tax on both in-state income and out-of-state income for state residents; and in-state income for non-residents. To be concrete, the first state is a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin) which claims all my income derived in the state and half of Jacqui's income as taxable as long as we were the residents of that state. The 2nd state is better in the sense that it will claim Jacqui's 100% income as taxable while my income as taxable only if I am a resident of the state.
Generally speaking, married filing jointly shows less Federal tax compared to filing separately. On the other hand, filing separately would allow us to claim resident status in two states separately, which minimizes our state taxes. However, you cannot mix and match. You need to have the same state filing status as the Federal filing status. Filing separately disqualifies us as a couple from Roth IRA contributions (AGI > 10000), which we already made in early 2006. We could withdraw our IRA contributions and pay taxes on capital gains before this April 16th; however that will be quite a hassle. For the reasons I stated before, I do not want to lose this tax benefit.
As the state income taxes do not amount that much compared to federal taxes, my strategy is to file tax return jointly, but try to minimize state taxes. The solution is to establish the domicile for both of us (permanent legal address) in the new state with lower income tax rates as soon as possible (since Jacqui moved there), so that Jacqui's job income (higher than my PhD student stipend) will be taxed only in the new state. Of course, as I moved to the current state, my income in the 2nd half of the year become taxable in the current state as well. However, I found a schedule to claim a tax credit for the tax rate paid and the previous state. Most states have similar schedules for you to claim credits on taxes paid to other state governments, however, usually the lower-rate states give credits only up to an allowance computed using lower-rates. So you could avoid being double-taxed, but will still be taxed at higher rate if unlucky.Labels: federal tax, income tax, IRA, Money, Roth, state tax, Tax, TaxCut |
| posted by Yannick @ 1:41 PM | Add to del.icio.us
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| Monday, March 19, 2007 |
| Roth IRA, a must-have tax benefit for graduate students and young professionals! |
One common enemy on wealth accumulation for busy young fellows is not to start now. A few years ago, I started to work on my financial plan. The first thing I realized was how much I had missed by not using Roth IRA.
IRA is the abbreviation for individual retirement account. There are two types of IRA, traditional IRA and Roth IRA, sharing the same annual quota ($4000 for 2006) set by the Congress. For a traditional IRA account, you take a tax deduction up front for the money you put into the account, the contributions and earnings are not taxed until its distribution after retirement, which is called tax deferment. For a Roth IRA account, you put in after-tax money as contributions, your contributions and earnings grow tax-free even when it is distributed after your retirement.
For young professionals and poor graduate students, Roth IRA is better for the following reasons:
1. You will be likely in a higher tax bracket at your retirement compared to your tax brackets now. Most graduate students on a stipend are in the tax bracket of 15%. Compared to a 25% plus tax bracket with a real salary, Roth IRA is a big saving. Also, if you are an optimist believing in brighter future and higher earnings down the road, or if you are a pessimist believing in increasing Federal tax rates, you should contribute to Roth IRA instead of traditional IRA. Of course, if you are extremely pessimistic and worried about the Congress removing the tax benefits of existing Roth IRA in the future, you probably should store up gold and avoid investing.
2. It is more flexible. You can have early withdraws any time up to the total contributions without penalty. Of course, you won't be able to put them back in later. So it's NOT recommended. However, it was really attractive to me when I started as I was considering graduation and buying a house after getting a job.
3. No mandatory age-based distribution schedule like other tax-deferred retirement accounts. This allows you to manage your income stream after retirement, and enable you to pass all the dough to your descendants even.
4. You contribute more with Roth. Because the quota is applied on your after-tax contributions, $4000 in a Roth IRA is really worth more than the pre-tax $4000 in a traditional IRA. Therefore, it's very attractive to a late-starter who is trying to catch up with the retirement contributions.
Now let's see how much you can accumulate with Roth IRA only. Assuming an annual contribution of $4,000.00 in 2006 and 2007, and $5000 afterwards (the limit will be increased to $5000 in 2008), you will see $1,049,385 in 2041 if the annualized rate of return is 9%. Assuming you start at the age of 30, more than 1 million dollars will be there for you at the age of 65 tax-free. After considering an annual inflation rate of 3%, it's still worth $544,822 of current dollars. Half a million in today's dollar is probably worth more than most people's equity in their house after they have paid off a thirty-year mortgage. Find a soul-mate and do it together? That will be even sweeter!
So if you haven't taken advantage of the Roth IRA, I highly recommend you to do it. The deadline for 2006 contributions is 04/16/2007. You've still got time!Labels: Investment, IRA, Planning, Retirement, Roth, Tax |
| posted by Yannick @ 3:07 PM | Add to del.icio.us
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| Friday, March 16, 2007 |
| Even More Unpleasant Tax Return Filing Experience |
I have been quiet for a while. The reason? Quite exhaustive travels, reading a good investment book and filing for tax returns.
Tonight I had been working on a state income tax return, whose tax forms were in encrypted PDF format. It means that you can only print it to a physical printer, but not save it with data filled in, which is really a pain in the neck. I could not file online because of some complicated issues. However, I would like to fill the data in the pdf files electronically since it's cleaner and I can also keep an electronic copy of my tax returns. I do not understand why they wanted to create even more trouble for poor people who need to file off-line! It's a well-known trade-off between convenience and security, however, I can not believe that people would create such unnecessary inconvenience for no gain in security at all!!!
I was a bit nervous because it was not easy to work back and forth between 7 forms (Federal plus State) and quite a few browser windows without making any mistakes. I was unlucky with my computers many times, thus, even I didn't close any window mistakenly, the applications and Windows may well crash when I was working.
After a whole night's hard work, I finally got to print them out before losing them despite a glitch in printing. Whew!Labels: Commentary, Tax |
| posted by Yannick @ 9:03 PM | Add to del.icio.us
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| Sunday, February 25, 2007 |
| More Tax Returns for International Students!!! |
Yannick and I have been students for so long that we were "forced" to become "sophisticated" senior students, at least financial-wise.
We came from China. There is an annual $5,000 exclusion of a student’s wages for the first 5 years. We were very happy back then, because we were optimistic that we could finish our PhD's in 5 years.
As you know now that we did not accomplish our mission within 5 years. In the 6th year, as we were grudging the loss of the "$5000 exclusion of students wages", we started extensive research on tax laws, treaties, and even attended a PhD level taxation seminar! (You see, there is a reason that we stayed in graduate schools for such a long time).
And you know what? Our efforts did get rewarded! Here is what we found: The tax treaty from the People's Republic of China (PRC) contains no time limit, and a Chinese student who qualifies for it may use the article for as long as he is still in valid F-1 status, including during that period in which he is engaged in practical training in valid F-1 status.
So, if you are from P.R.C, still a student after 5 years in U.S., and believe in "NO Taxation Without Representation", here is something we want to share with you. Hopefully this will save you some time, and help you get out of graduate school early.
Step by Step instruction to get you $5,000 tax exclusion:
I. Download Form 8833 .
II. Fill out the form like this:
1. Enter the specific Treaty position relied on:
(a) Treaty country: People’s Republic of China
(b) Articles: 20(C), Paragraph 2 of 04-30-1984 prot.
2. List the internal revenue code provisions overruled or modified by the treaty asked return position: IRC61; 871(b)
3. Name, identifying number of …. : N/A
4. List the provision(s) of the limitation on benefits…: N/A
5. Explain the treaty-based return position taken:
The taxpayer is a citizen of the People's Republic of China. He entered the United States on on an F-1 visa (student), and has remained in F-1 status continuously since. Under the residency rules of IRC7701 (b), the taxpayer passed the substantial presence test in and his residency starting date was 01-01-. This means that for 2006, the taxpayer is a resident alien and is filing form 1040 for 2006 as a resident alien.
Article 20(c) of the USA-China income tax treaty allows an annual $5000 exclusion of student wages from gross income. The article contains no time limit, and a Chinese student who qualifies for it may use the article for as long as he is a bona fide student in valid F-1 status. Paragraph 2 of the 04-30-1984 protocol of the USA-China income tax treaty contains the "saving clause" of the treaty, which normally acts to nullify the tax treaty's benefits once a resident of China has become a resident of the USA. However, paragraph 2 of the Protocol also specifies exceptions to the saving clause, among which is article 20 on student and trainees. This means that, even though the taxpayer has become a resident alien under the substantial present test of IRC 7701(b), he may still claim the benefit of article 20 of the USA-China income tax treaty. The taxpayer has elected to do this, and is claiming an exclusion from gross income for 2006 of $5,000 in student wages as allowed by article 20(c) of the USA-China income tax treaty. TOTAL EXCLUSION CLAIMED: $5,000
Gong Xi Fa Cai!Labels: International Tax Treaty, Tax |
| posted by Jacqui @ 6:17 AM | Add to del.icio.us
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| Saturday, February 24, 2007 |
| Non-Resident Alien or Resident Alien? |
A blog friend started a discussion on tax filing for Aliens here . Yannick and I have been filing as Non-resident alien and then Resident alien for years, and we may have to file as "Aliens" for a few more years if the Green Card waiting lines gets longer :( So we can not help sharing our experience.
EDIT:
I realized that my discussion on the topic with mOOm and Golbguru was a bit too fragmented. Therefore, I am recompiling my comments in the following:
F-1 and J-1 student visa holders are generally considered nonresident aliens for any part of the first five calendar years they are in the U.S. in that visa status. F-1 and J-1 students who have been in the U.S. for more than five consecutive calendar years are considered to be resident aliens for tax purposes.
To know why, first you should know that IRS is mainly concerned with the number of years you've been to US, not your immigration status defined by INS (USCIS recently).
You can get the spirit of the tax law from the IRS publication :
"The residency rules for tax purposes are found in I.R.C. § 7701(b). Although the tax residency rules are based on the immigration laws concerning immigrants and nonimmigrants, the rules define residency for tax purposes in a way that is very different from the immigration laws. Under the residency rules of the Code, any alien who is not a RESIDENT ALIEN is a NONRESIDENT ALIEN. An alien will become a RESIDENT ALIEN in one of three ways:
(1) by being admitted to the United States as, or changing status to, a Lawful Permanent Resident under the immigration laws (the Green Card test);
(2) by passing the Substantial Presence Test (which is a numerical formula which measures days of presence in the United States);
or (3) by making what is called the "First Year Election" (a numerical formula under which an alien may pass the Substantial Presence Test one year earlier than under the normal rules).
Under these rules, even an undocumented (illegal) alien under the immigration laws who passes the Substantial Presence Test will be treated for tax purposes as a RESIDENT ALIEN."
So the Substantial Presence Test is the relevant part for most F1 or J1 holders.
In the IRS Publication 519, US Tax Guide to Aliens, it says that you don't count any day you are an F1 student towards presence in the US for the substantial presence test. However, after saying students (F1) were one of the "exempt" cases, the "exempt" status were automatically taken away after 5 years.
"You will not be an exempt individual as a student if you have been exempt as a teacher, trainee, or student for any part of more than 5 calendar years unless you establish that you do not intend to reside permanently in the United States and you have substantially complied with the requirements of your visa."
So enjoy the Resident Alien status which allows you to claim same number of deductions as a US Citizen after five years of consecutive F1 status and claim tax treaty benefit if your country has a tax treaty with the US. Even better, full-time students enrolled in a university and working part-time for the same university are exempted from FICA payroll taxes.Labels: Green Card, Non-Resident Alien, Resident Alien, Tax |
| posted by Jacqui @ 5:42 PM | Add to del.icio.us
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