E.37 Income tax fundamentals and calculations Flashcards
Learners will be able to identify and apply the fundamental concepts and calculations related to income tax, including taxable income determination, tax rates, deductions, and credits.
Elena recently experienced several financial events: she received her monthly salary, earned interest on her savings account, inherited some money from her late aunt, and collected rent from a property she owns. Which of these sources of income is NOT considered taxable income?
A. Monthly salary
B. Interest earned on her savings account
C. Inheritance received
D. Rental income
C. Inheritance received
Generally, inheritances are not considered taxable income for federal income tax purposes. While estates may be subject to estate taxes, the recipient of an inheritance does not include it as taxable income. In contrast, wages, interest from savings accounts, and rental income are all considered taxable income and must be reported on a tax return.
E.37 Income tax fundamentals and calculations
Michael, a 45-year-old graphic designer, is planning for his retirement and is exploring various savings options. He is particularly interested in tax-deferred retirement accounts where he can save money and defer taxes until withdrawal in retirement. Which of the following options should he consider?
A. Traditional IRA
B. Roth IRA
C. Health Savings Account
D. 529 Plan
A. Traditional IRA
A Traditional IRA (Individual Retirement Account) allows contributions to grow tax-deferred, meaning that taxes on contributions and earnings are paid only when withdrawals are made in retirement. This is in contrast to a Roth IRA, where contributions are made with after-tax dollars and withdrawals are tax-free. Health Savings Accounts and 529 Plans have specific purposes for healthcare and education expenses, respectively, and are not primarily retirement accounts.
E.37 Income tax fundamentals and calculations
John and Jane, a married couple, have a portfolio that is comprised of stocks at LMN Brokerage and tax-exempt bonds at DEF Brokerage. Their investment income is as follows:
- Interest from banks: $2,500
- Non-qualifying dividends from LMN Brokerage: $2,500
- Tax-exempt interest subject to alternative minimum tax (AMT) from DEF Brokerage: $2,500
- Tax-exempt interest not subject to alternative minimum tax (AMT) from DEF Brokerage: $4,000
John and Jane file a joint federal tax return, have an adjusted gross income (AGI) of $65,000, and itemize their deductions. They paid investment interest of $3,000 to LMN and $2,500 to DEF. Assuming no special elections, what amount of investment interest expense is deductible for regular tax purposes on their federal income tax return?
A. $3,000
B. $5,000
C. $5,500
D. $6,000
E. $7,500
B. $5,000
The investment interest expense deduction is limited to the couple’s net investment income.
Net investment income includes:
* Interest from banks: $2,500
* Non-qualifying dividends from LMN Brokerage: $2,500
(We don’t include tax-exempt interest for this calculation.)
Total net investment income: $5,000
E.37 Income tax fundamentals and calculations
Jane and John, both aged 58 and 55 respectively, purchased their primary residence 17 years ago for $300,000. Over the years, they have spent $80,000 on renovations. They fall under the 32% marginal federal tax bracket. Last year, they utilized one of the rooms in their home as an office for their design business, which led to a depreciation expense of $1,500 against their Schedule C earnings. This year, they sold the property for $750,000. From the sale, they had to pay a broker fee of $50,000 and clear their remaining mortgage of $480,000. How should they report the sale of the house on their income tax returns?
A. Exclude gain of $340,000 from taxable income and pay a 25% tax on $1,500
B. Exclude the entire transaction from taxable income
C. Include the long-term capital gain of $340,000 in their taxable income
D. Report ordinary income of $1,500
A. Exclude gain of $340,000 from taxable income and pay a 25% tax on $1,500
Jane and John can exclude up to $500,000 of gain from the sale of their primary residence if they meet certain requirements. The gain is calculated as:
Sale price ($750,000) - Purchase price ($300,000) - Improvements ($80,000) - Broker commission ($50,000) = $320,000.
However, they have to recapture the $1,500 of depreciation they claimed, which is taxed at 25%. Thus, they can exclude the gain of $340,000 from their taxable income and pay a 25% tax on the $1,500 depreciation.
E.37 Income tax fundamentals and calculations
For a taxpayer who is in the 32% marginal tax bracket and itemizes deductions, which of the following would provide the LEAST income tax savings?
A. $1,320 child support payments
B. $1,000 of additional itemized deductions
C. $800 short-term capital loss
D. $355 tax credit
A. $1,320 child support payments
For the options provided, here’s a breakdown of their potential tax savings:
Child support payments are neither deductible for the payer nor taxable to the recipient. Therefore, they provide no tax savings.
$1,000 of additional itemized deductions would provide a tax saving of $1,000 x 32% = $320.
An $800 short-term capital loss would provide a tax saving of $800 x 32% = $256.
A tax credit is a dollar-for-dollar reduction in the tax owed. Therefore, a $355 tax credit would provide $355 in tax savings.
Comparing the savings from each option, the $1,320 child support payments (Option A) would provide the least income tax savings, which is zero.
E.37 Income tax fundamentals and calculations
A financial advisor is working with Monica, who owns an upscale watch boutique and falls into the 35% income tax bracket. Monica is considering liquidating one of four assets, each with a fair market value of $30,000 and a cost basis of $18,000. She has owned all the assets for over 1 year. To maximize her after-tax cash flow, which asset should Monica sell?
A. A sapphire watch from her store inventory.
B. A sculpture from her private art gallery.
C. A silver brooch she crafted herself.
D. Google stock from her investment account.
D. Google stock from her investment account.
The assets’ capital gains would be taxed at long-term capital gains rates since Monica has held them for over a year. Typically, the long-term capital gains rate is lower than the ordinary income tax rate. Selling an asset from her store inventory or something she crafted herself would be considered ordinary income and taxed at her income tax rate (35% in this case). The Google stock, being an investment, would be taxed at the lower long-term capital gains rate, thereby providing the maximum after-tax cash flow.
E.37 Income tax fundamentals and calculations
Scenario: John, a single filer, earned $85,000 in taxable income this year. He wonders how much federal income tax he will owe. According to the IRS tax brackets for this year, if you are a single filer, the rates are:
10% on income from $0 to $9,950
12% on income from $9,951 to $40,525
22% on income from $40,526 to $86,375
What is John’s federal income tax liability for this year?
Options:
A. $14,605
B. $15,473
C. $18,529
D. $16,889
B) $15,473
To calculate John’s tax:
10% of $9,950 = $995
12% of ($40,525 - $9,950) = $3,669
22% of ($85,000 - $40,525) = $9,809
Total tax = $995 + $3,669 + $9,809 = $15,473
E.37 Income tax fundamentals and calculations
Scenario: Sarah and Tom are married filing jointly. They earned $120,000 in wages and had $15,000 in long-term capital gains. Their standard deduction is $29,200. Based on this information alon e, what is their taxable income for the year?
Options:
A. $105,800
B. $95,000
C. $134,900
D. $110,000
A. $105,800
Taxable income = ($120,000 + $15,000) - $29,200 = $105,800
E.37 Income tax fundamentals and calculations
Alice is considering the tax implications of selling a stock she has owned for 13 months. What kind of capital gains tax will she most likely be subject to?
A. Short-term capital gains tax
B. Long-term capital gains tax
C. Ordinary income tax
D. No capital gains tax is applicable
B. Long-term capital gains tax
Long-term capital gains tax rates apply to assets held for more than one year before being sold. Alice held her stock for more than 12 months, thus qualifying her gains as long-term capital gains.
E.37 Income tax fundamentals and calculations
Bob, who is in the 32% income tax bracket, is evaluating whether to make a deductible IRA contribution. How does a deductible IRA contribution affect his taxable income?
A. Increases his taxable income
B. Decreases his taxable income
C. Has no effect on his taxable income
D. Changes his tax bracket
B. Decreases his taxable income
Making a deductible IRA contribution reduces an individual’s gross income, which in turn lowers their taxable income. This reduction can potentially result in paying less in taxes.
E.37 Income tax fundamentals and calculations
Which of the following scenarios would likely make someone subject to the Alternative Minimum Tax (AMT)?
A. Having a large number of dependents
B. Earning primarily wage income
C. Making large charitable contributions
D. Frequent exercising of incentive stock options
D. Frequent exercising of incentive stock options
The AMT is designed to ensure that taxpayers who receive certain tax preferences pay at least a minimum amount of tax. Exercising incentive stock options can lead to large paper gains which are preferentially treated under regular tax but taxable under AMT.
E.37 Income tax fundamentals and calculations
Charlotte received a substantial raise at her job this year. Which of the following is a true statement regarding her filing status and tax brackets?
A. Tax brackets vary significantly based on filing status.
B. Filing status does not affect tax brackets.
C) Only marital status, not income, affects tax brackets.
D. All taxpayers are subject to the same tax rates regardless of income or filing status.
A. Tax brackets vary significantly based on filing status.
Tax brackets in the U.S. are structured differently based on the taxpayer’s filing status (e.g., single, married filing jointly, etc.). These differences can result in different tax liabilities for taxpayers with the same income but different filing statuses.
E.37 Income tax fundamentals and calculations
Eleanor is self-employed and uses her home office exclusively for business. Which of the following is correct regarding the deduction for home office expenses?
A. She cannot claim home office expenses since she owns the home.
B. She can deduct a portion of household expenses based on the percentage of her home used for business.
C. The home office deduction is only available to employees of a company.
D. Home office deductions are standardized and not based on the actual expenses.
B. She can deduct a portion of household expenses based on the percentage of her home used for business.
Self-employed individuals can deduct home office expenses if the space is used exclusively for business. The deduction is typically based on the percentage of the home’s square footage that the office occupies, including a proportionate share of utilities, property taxes, and maintenance costs.
E.37 Income tax fundamentals and calculations
Jacob has multiple sources of income, including dividends from investments and a salary. What type of income do qualified dividends receive with regards to federal taxation?
A. They are taxed as ordinary income.
B. They are exempt from federal taxes.
C. They are subject to a lower tax rate than ordinary income.
D. They are taxed at the same rate as capital gains.
C. They are subject to a lower tax rate than ordinary income.
Qualified dividends are taxed at the capital gains tax rates, which are generally lower than the rates for ordinary income.
E.37 Income tax fundamentals and calculations
Which of the following taxpayers would benefit from itemizing deductions on their federal tax return?
A. A taxpayer who only has the standard deduction amount in total deductions.
B. A taxpayer whose combined deductions are less than the standard deduction.
C. A taxpayer whose combined deductions exceed the standard deduction.
D. A taxpayer who is subject to the Alternative Minimum Tax.
C. A taxpayer whose combined deductions exceed the standard deduction.
Taxpayers benefit from itemizing deductions when their total deductible expenses for the year exceed the standard deduction amount available for their filing status.
E.37 Income tax fundamentals and calculations
