Question

Explain how the technique of laddering can be used by investors in CDs to smooth out interest rate fluctuations.

Summarize the differences between a traditional individual retirement account (IRA) and a Roth IRA.

Answer 1

CD laddering is a strategy wherein an investor, instead of putting all money in single CD and renewing it over the period, will invest the money in different CDs with different maturities. So instead of putting all the money today, investor will invest the money in staggered way.

For example, assume you have $50,000 to invest and you have choosen CD as your instrument to invest in. Now, instead of putting all your money in as single CD, you can divide this equally and put $10,000 into 5 different CD with different maturities

if you invest in single CD, you amonut gets locked and there is penelaties if you want to withdraw your money before maturiry. This means that you are exposed to interest rate risk since your rate is locked when you bought the CD. This is not the case with laddering. By laddering, you are investing money in different maturities of CDs which helps you to smoothen out the interest fluctuations. Suppose, there is huge fluctuation in interest rates after 1 year you have invested your money. In single CD, you cannot do anything and have to give penelty if you want to withdraw. But with laddering, you can withdraw your money at that time and invest in higher return avenues.

Difference between traditional and roth IRAs

1. There is age limit in Traditional IRA but no restriction on the income anyone earned. Any person who is earning and younger than 70.5 years can invest in traditional IRA

But in Roth IRA, there is a eligibility critirea in Roth IRA. No age restricions though. So to invest in Roth IRA, you must have modified adjusted gross incomes less than $135,000

2. Both IRAs provide tax benefits but timings are different

Traditional IRA provide tax break on contribution but withdrwals are taxed.

In Roth IRA, it is other way around. Contibutions are taxed while withdrawls are tax free.

3. There is differnce in withdrawls rule also.

Traditional IRA, you have to withdraw the minimum amount regularly once you cross the age of 70.5

Roth IRA, there is no such restriction. Your money can be invested for your whole life time.