IV. Federal Taxation of Individuals-Income

Question 1

IV. Federal Taxation of Individuals-Income

81. Gross Income—General Concepts and Interest

Which of the following statements is correct with regard to an individual taxpayer who has elected to amortize the premium on a bond that yields taxable interest?

1. The amortization is treated as an itemized deduction.
2. The amortization is not treated as a reduction of taxable income.
3. The bond’s basis is reduced by the amortization.
4. The bond’s basis is increased by the amortization.

Answer 1

3.

An individual taxpayer who has elected to amortize the premium on a bond that yields taxable interest may reduce the bond’s basis by the amortization of the premium. In addition, the amount of bond premium attributable to the tax year may be used to offset interest received on the bond in computing the taxpayer’s taxable income.

This response correctly states that the bond’s basis is reduced by the amortization.

Question 2

81. Gross Income—General Concepts and Interest

Clark bought series EE U.S. Savings Bonds in 2019. Redemption proceeds will be used for payment of college tuition for Clark’s dependent child. One of the conditions that must be met for tax exemption of accumulated interest on these bonds is that the

1. Purchaser of the bonds must be the sole owner of the bonds (or joint owner with his or her spouse).
2. Bonds must be bought by a parent (or both parents) and put in the name of the dependent child.
3. Bonds must be bought by the owner of the bonds before the owner reaches the age of 24.
4. Bonds must be transferred to the college for redemption by the college rather than by the owner of the bonds

Answer 2

1.

Taxpayers redeeming qualified U.S. Series EE Bonds in the same year that qualified higher education expenses are paid may exclude the interest income on the bonds from gross income.

1. The conditions that must be met for tax exemption of accumulated interest on these bonds is that
2. the purchaser of the bond must have made the purchase after reaching the age of 24 and
3. be the sole owner of the bonds (or joint owner with his or her spouse).

Question 3

81. Gross Income—General Concepts and Interest

In 2020, Clark filed Form 1040 for the 2019 taxable year. Clark did not itemize his deductions. In 2020, Clark received a state income tax refund of $900 plus interest of $10 for overpayment of 2019 state income tax.

What amount of the state tax refund and interest is taxable in Clark’s 2020 federal income tax return?

1. $0
2. $10
3. $900
4. $910

Answer 3

2.

Federal and state income tax refunds are excluded from a taxpayer’s taxable income to the extent that the refund did not reduce the amount of tax for the earlier year. However, any interest earned on these refunds is considered taxable income.

Thus, Clark’s state income tax refund is excluded from taxable income. However, the $10 in interest income from the refund is taxable income and, therefore, included on Clark’s 2020 federal income tax return.

Question 4

81. Gross Income—General Concepts and Interest

During 2019, Kay received interest income as follows:

On U.S. Treasury certificates$4,000

On refund of the prior year’s federal income tax$500

The total amount of interest subject to tax in Kay’s 2019 tax return is

1. $4,500.
2. $4,000.
3. $500.
4. $0.

Answer 4

1

Interest income received on U.S. Treasury certificates is not exempt from federal income tax. In addition, while federal income tax refunds are nontaxable, the interest received on the refund is taxable income.

Hence, the interest income on the U.S. Treasury certificates and on the refund of prior year’s federal income tax is reported on Kay’s 2019 tax return, putting the total amount of interest subject to tax in Kay’s 2019 tax return at $4,500.

Question 5

81. Gross Income—General Concepts and Interest

In 2018, Stewart Corp. properly accrued $5,000 for an income item on the basis of a reasonable estimate. In 2019, after filing its 2018 federal income tax return, Stewart determined that the exact amount was $6,000.

Which of the following statements is correct?

1. No further inclusion of income is required in 2019 as the difference is less than 25% of the original amount reported and the estimate had been made in good faith.
2. The $1,000 difference is includible in Stewart’s income tax return.
3. Stewart is required to notify the IRS within 30 days of the determination of the exact amount of the item.
4. Stewart is required to file an amended return to report the additional $1,000 of income.

Answer 5

2.

Under the accrual method of accounting, income is reported once all events to establish a taxpayer’s right to receive the income have occurred and the amount can be determined with reasonable accuracy.

If an amount of income has been accrued on the basis of a reasonable estimate with the exact amount to be determined at a later date, any difference between the estimate and exact amount is to be included in income or deducted in the year when the exact amount can be determined.

Question 6

82. Gross Income—Gross Income—Other Inclusions

V. Damages

Answer 6

Personal Injuries—Damages for physical injury or physical sickness are excluded.

1. If an action has its origin in a physical injury or physical sickness, then all damages therefrom (other than punitive damages) are excluded (e.g., damages received by an individual on account of a claim for loss due to a physical injury to such individual’s spouse are excludible from gross income).
2. Damages (other than punitive damages) received on account of a claim of wrongful death and damages that are compensation for amounts paid for medical care (including medical care for emotional distress) are excluded.
3. Emotional distress is not considered a physical injury or physical sickness. No exclusion applies to damages received from a claim of employment discrimination, age discrimination, or injury to reputation (even if accompanied by a claim of emotional distress).
4. Punitive damages generally must be included in gross income, even if related to a physical injury or physical sickness.

Question 7

82. Gross Income—Gross Income—Other Inclusions

In a 2018 divorce settlement, the ex-husband was required by court order to pay his ex-wife $36,000 in alimony in 2019. She received $25,000 in cash, a painting valued at $10,000, and the use of his beach house, valued at $3,000. What amount of gross income should she report as alimony?

1. $25,000
2. $35,000
3. $36,000
4. $38,000

Answer 7

1.

Alimony must be received in cash so the painting and beach house do not qualify. The cash is included in income since the divorce was finalized before 2019.

Question 8

83. Gross Income—Exclusions

Robert Hall served in the U.S Army and received a full medical discharge and was declared 100% disabled in 2019. Robert had accrued $35,000 in student loans prior to his service in the military. During 2019, the student loan was completely forgiven. The loan has an applicable federal interest rate of 5.9%. How much of the loan and interest must Robert include in gross income?

1. $0
2. $2,065
3. $35,000
4. $37,065

Answer 8

1.

Gross income does not include debt forgiveness for student loans that are forgiven because of the death or disability of the creditor.

Question 9

83. Gross Income—Exclusions

In 2019, Joan accepted and received a $10,000 award for outstanding civic achievement. Joan was selected without any action on her part, and no future services are expected of her as a condition of receiving the award. What amount should Joan include in her 2019 adjusted gross income in connection with this award?

1. $0
2. $ 4,000
3. $ 5,000
4. $10,000

Answer 9

4.

Joan meets all of the requirements to exclude the gift from income, except that she accepted the award and received payment. Therefore, the FMV of the award, $10,000, is included in her income.

Prizes or awards can be excluded if they are for civic, artistic, educational, scientific, or literary achievement and the recipient is:

1. Selected without action on his/her part;
2. Not required to perform services; and
3. If the amount is paid directly to a tax-exempt or governmental organization.

Question 10

84. Taxation of Income from Business Entities

Stock dividends basis

Answer 10

T owns 100 shares of XYZ Corp. common stock that was acquired in 2012 for $12,000. In 2019, T received a nontaxable distribution of 10 XYZ Corp. preferred shares. At date of distribution the FMV of the 100 common shares was $15,000, and the FMV of the 10 preferred shares was $5,000. The portion of the $12,000 basis allocated to the preferred and common shares would be

$5,000

• Preferred= ————————- ($12,000) = $3,000

$5,000+$15,000

$15,000

• Common= ————————- ($12,000) = $9,000

$5,000+$15,000

Question 11

84. Taxation of Income from Business Entities

Stock dividends basis

Answer 11

1. To be nontaxable, the stock dividend must be paid to common stockholders. Either common or preferred stock can be paid to common stock shareholders. A stock dividend paid to preferred stockholders is always taxable.
2. Dividends received from life insurance policies are excluded from income if the total dividends received have not yet exceeded the accumulated premiums paid. In this case the dividend is treated as a reduction of the cost of the insurance.

Question 12

84. Taxation of Income from Business Entities

Farming Income and Expenses

Answer 12

1. A farmer may generally deduct soil and water conservation expenditures that are consistent with a conservation plan approved by a federal or state agency. However, the deduction is annually limited to 25% of the farmer’s gross income from farming. Excess expenses can be carried over for an unlimited number of years subject to the 25% limitation in each carryover year.
   
   1. Expenses related to the draining of wetlands or to land preparation for the installation of center pivot irrigation systems may not be deducted under this provision.
   2. Land clearing expenses must be capitalized and added to the farmer’s basis in the land.

Question 13

84. Taxation of Income from Business Entities

V. Qualified Business Income Deduction

Answer 13

1. The QBI deduction is not a deduction for Adjusted Gross Income nor an itemized deduction. Rather, the QBI deduction is deducted FROM adjusted gross income but is not an itemized deduction.
2. QBI must be derived from a qualified business, which includes businesses conducted as a sole proprietor and flow-though income from partnerships, limited liability companies, and S corporations. It does not include performance of services by an employee.
3. A qualified trade or business does not include specified service trades or businesses. These are defined as performance in the services of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset is the reputation of an employee or owner. Note that income earned by architects and engineers is from a qualified trade or business.
4. This exclusion does not apply to specified service trades or businesses if taxable income of the taxpayer does not exceed $321,400 (2019—married filing joint), $160,725 (2019—married filing separately), or $160,700 (2019—others). The exclusion is phased out above these limits on a pro rata basis over a $100,000 (joint) or $50,000 (others) range.
5. The QBI deduction cannot exceed the greater of:
   
   • 50% of the taxpayer’s share of the W-2 wages paid by the business, or
   • 25% of the taxpayer’s share of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis of qualified property.
6. The wages/property limitation does not apply to taxpayers with taxable income not exceeding $321,400 (married filing joint), $160,725 (2019—married filing separately), or $160,700 (others). If taxable income exceeds these thresholds, the limitation is phased in over a $100,000 (joint)/$50,000 (others) range.

Question 14

84. Taxation of Income from Business Entities

V. Qualified Business Income Deduction

limitations that affect the QBI deduction

Answer 14

QBI Limitations

2019 Modified Taxable Income

Filing Status COLUMN 1 COLUMN 2 COLUMN 3

Married Filing Jointly ⇐ $321,400 > $321,400 and < $421,400 > = $421,400

Married Filing Separate ⇐ $160,725 > $160,725 and < $210,725 > = $210,725

Other ⇐ $160,700 > $160,700 and < $210,700 > = $210,700

Wage/Asset Limitation Limitation does not apply Limitation phased-in; Wage limitation fully partially applies phased-in

Specified Services Lim. Limitation does not apply; QBI deduction QBI deduction not QBI deduction allowed partially allowed allowed

20% of Taxable Income Yes Yes Yes

Limitation Applies?

Question 15

84. Taxation of Income from Business Entities

Robin Byrd is a self-employed accountant with Schedule C profit of $320,000. Her business does not pay any W-2 wages. Robin is married filing a joint return and has taxable income of $275,000, prior to the Section 199A deduction. What is the amount of Robin’s qualified business income deduction, if any?

1. $0
2. $55,000
3. $64,000
4. $100,000

Answer 15

2.

CORRECT! The QBI deduction is computed separately for each trade or business and is 20% of the qualified business income. The QBI deduction cannot exceed the greater of:

50% of the taxpayer’s share of the W-2 wages paid by the business, or

25% of the taxpayer’s share of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis of qualified property.

The wages/property limitation does not apply to taxpayers with taxable income not exceeding $321,400 (married filing joint), $160,725 (married filing separately) or $160,700 (others). Since Robin’s taxable income is $275,000 and she is married filing joint, her QBI deduction is $64,000. However, the deduction is limited to 20% of the excess of the taxpayer’s taxable income over the taxpayer’s net capital gains (including qualified dividends), which is 20% × $275,000 = $55,000.

Question 16

84. Taxation of Income from Business Entities

Amy Finch had the following cash receipts during 2019:

Dividend from a mutual insurance company on a life insurance policy $500

Dividend on listed corporation stock; payment date by corporation was 12/30/18, but Amy received the dividend in the mail on 1/2/19 875

Total dividends received to date on the life insurance policy do not exceed the aggregated premiums paid by Amy. How much should Amy report for dividend income for 2019?

1. $1,375
2. $ 875
3. $ 500
4. $0

Answer 16

2.

Dividends are included in income at earlier of actual or constructive receipt. When corporate dividends are paid by mail, they are included in income for the year in which received. Thus, the $875 dividend received 1/2/19 is included in income for 2019. The $500 dividend on a life insurance policy from a mutual insurance company is treated as a reduction of the cost of insurance and is excluded from gross income.

Question 17

84. Taxation of Income from Business Entities

During 2017, Karen purchased 100 shares of preferred stock of Boling Corp. for $5,500. During 2019, Karen received a stock dividend of ten additional shares of Boling Corp. preferred stock. On the date the preferred stock was distributed, it had a fair market value of $60 per share. What is Karen’s basis in the ten shares of preferred stock that she received as a dividend?

1. $0
2. $500
3. $550
4. $600

Answer 17

4.

Generally, stock dividends are nontaxable, and a taxpayer’s basis for original stock is allocated to the dividend stock in proportion to fair market values. However, any stock that is distributed on preferred stock results in a taxable stock dividend. The amount to be included in the shareholder’s income is the stock’s fair market value on date of distribution. Similarly, the shareholder’s basis for the dividend shares will be equal to their fair market value on date of distribution (10 × $60 = $600).

Question 18

85. Accounting Methods and Periods—Individuals

Costs required to be capitalized:

Answer 18

1. Costs required to be capitalized under the uniform capitalization rules include direct materials and direct labor, and virtually all indirect production (such as utilities, repairs, rent, depreciation) costs must be capitalized for tax purposes.
2. Marketing, selling, advertising, and distribution expenses are not required to be capitalized under the uniform capitalization rules. General and administrative expenses also do not have to be capitalized.

Question 19

85. Accounting Methods and Periods—Individuals

installment method

Gross profit

—————————————– × Amount received in year

Total contract price

(selling price-liab. assumed)

• Contract price is the selling price reduced by the seller’s liabilities that are assumed by the buyer, to the extent not in excess of the seller’s basis in the property. The gross profit percentage is the Gross profit/Contract price.

Answer 19

1. Taxpayer sells property with a basis of $80,000 to buyer for a selling price of $150,000. As part of the purchase price, buyer agrees to assume a $50,000 mortgage on the property and pay the remaining $100,000 in 10 equal annual installments together with adequate interest. The amount realized is $150,000—the $100,000 cash to be received plus $50,000 debt relief.
   The contract price is the amount realized less the debt relief, or $100,000 ($150,000 – $50,000); the gross profit is $70,000 ($150,000 – $80,000); and the gross profit percentage is 70% ($70,000 / $100,000). Thus, $7,000 of each $10,000 payment is reported as gain from the sale.
2. Assume the same facts as above except that the seller’s basis is $30,000. The contract price is $120,000 ($150,000 – Mortgage assumed but only to extent of seller’s basis of $30,000); the gross profit is $120,000 ($150,000 – $30,000); and the gross profit percentage is 100% ($120,000/$120,000). Thus, 100% of each $10,000 payment is reported as gain from the sale. In addition, the amount by which the assumed mortgage exceeds the seller’s basis ($20,000) is deemed to be a payment in the year of the sale. Since the gross profit ratio is 100%, all $20,000 is reported as gain in the year the mortgage is assumed.

Question 20

85. Accounting Methods and Periods—Individuals

installment method

In the current year, Essex sold land with a basis of $80,000 to Yarrow for $100,000. Yarrow paid $25,000 down and agreed to pay $15,000 per year, plus interest, for the next five years, beginning in the second year. Under the installment method, what gain should Essex include in gross income for the year of sale?

1. $25,000
2. $20,000
3. $15,000
4. $ 5,000

Answer 20

D.

The total recognized gain from the sale is $20,000 ($100,000 selling price – $80,000 basis). Under the installment method, recognized income = cash collected × (gross profit/contract price). Therefore, $25,000 × ($20,000/$100,000) = $25,000 × 20% = $5,000.

Question 21

85. Accounting Methods and Periods—Individuals

Ace Rentals Inc., an accrual-basis taxpayer, reported rent receivable of $35,000 and $25,000 in its 2019 and 2018 balance sheets, respectively. During 2019, Ace received $50,000 in rent payments and $5,000 in nonrefundable rent deposits.

In Ace’s 2019 corporate income tax return, what amount should Ace include as rent revenue?

1. $50,000
2. $55,000
3. $60,000
4. $65,000

Answer 21

D.

Ace Corp. would report rent revenue of $65,000. Of this amount, $55,000 (the sum of $50,000 in rental payments and $5,000 in nonrefundable rent deposits) would be cash receipts. Ace Corp. is an accrual based taxpayer. Therefore, for tax purposes, income is earned when (1) all the events have occurred to attach the taxpayer’s right to receive the income and (2) the amount of income can be determined with reasonable accuracy. With respect to rent receivable, the income must have been earned to record it as a receivable.

Hence, in calculating rent revenue, the $10,000 increase in rent receivable from 2018 to 2019 would have to be added to the corporation’s cash receipts.

Question 22

85. Accounting Methods and Periods—Individuals

Lake Corp., an accrual-basis calendar year corporation, had the following 2019 receipts:

2020 advanced rental payments where the lease ends in 2020$125,000

Lease cancellation payment from a 5-year lease tenant50,000

Lake had no restrictions on the use of the advanced rental payments and renders no services. What amount of income should Lake report on its 2019 tax return?

1. $0
2. $50,000
3. $125,000
4. $175,000

Answer 22

D.

For accrual-based taxpayers, items generally are included in gross income for the year in which the income is earned. However, for tax purposes, income is earned when (1) all the events have occurred to attach the taxpayer’s right to receive the income and (2) the amount of income can be determined with reasonable accuracy. Cash based taxpayers report income when it is actually received or constructively received (i.e., in the taxpayer’s control).

Since there are no restrictions on the advance lease payments or the lease cancellation payment and no services need to be rendered, Lake Corp. has a right to receive the advance lease payments and the lease cancellation payments in the current year. The payments also can be determined with reasonable accuracy. Hence, both the advance lease payments and the lease cancellation payments should be reported on Lake Corp.’s tax return.

This response includes both the advance lease payments and the lease cancellation payments in Lake Corp.’s taxable income.

Question 23

86. Taxation of Employee Benefits

Answer 23

>Employee Discounts

1. The discount is limited to 20% of the value of services.
2. The limit on the discount for purchases of merchandise is the average gross profit percentage for the employer.

>Safety and Length of Service Achievement Awards—Are excluded from income and are subject to a limit of $400 if not a qualified plan, and $1,600 if part of a qualified plan.

1. The award will be taxed if it is made in cash. “Cash” includes gift cards, gift coupons, gift certificates, vacations, meals, lodging, tickets for theater and sporting events, stock, bonds, and other nontangible personal property.
2. The award can be given only because of length of service or safety records.
3. The award can be given no more than once every five years.

>Transportation and Parking—Employer reimbursements for mass transit transportation ($265 per month) and parking ($265 per month) are excludible up to the limits shown in 2019.

>Reimbursement for commuting with a bicycle are included in income.

Question 24

86. Taxation of Employee Benefits

II. Fringe Benefits

P. Cafeteria Plans

Answer 24

1. Under a cafeteria plan, an employee can choose between cash and certain “qualified benefits.”
2. Cash is treated as wages.
3. Qualified benefits are tax-free benefits if they would have been tax-free if not offered through a cafeteria plan.
4. Qualified benefits include:
   
   1. Benefits/coverage under accident or health plans
   2. Long-term or short-term disability coverage
   3. Group-term life insurance coverage
   4. Dependent care assistance programs
   5. Section 401(k) plans
   6. Contributions through health savings accounts
   7. Adoption assistance

Question 25

86. Taxation of Employee Benefits

III. Stock Options

Incentive Stock Option Nonqualified Stock Option

Grant date None None

Exercise date None(except for AMT) Ordinary income

Sale date Ordinary income/capital gain(AMT reverses) ——

Empl’er Deduction employer does not employer receives

receive a deduction a salary deduction

Answer 25

1. Key Dates for Stock Options
   
   1. Grant date—Date the option is granted to employee.
   2. Exercise date—Date that the option is exercised and the stock is purchased.
   3. Sale date—Date that the stock is sold.
2. Nonqualified Stock Options
   
   1. No income is recognized when the option is granted.
   2. On the exercise date, the employee-recognized ordinary income is equal to:

(FMV of stock − Exercise price) × # of shares exercised.

Question 26

86. Taxation of Employee Benefits

Easel Co. has elected to reimburse employees for business expenses under a nonaccountable plan. Easel does not require employees to provide proof of expenses and allows employees to keep any amount not spent. Under the plan, Mel, an Easel employee for a full year, gets $400 per month for business automobile expenses. At the end of the year Mel informs Easel that the only business expense incurred was for business mileage of 12,000 at a rate of 30 cents per mile, the IRS standard mileage rate at the time. Mel encloses a check for $1,200 to refund the overpayment to Easel. What amounts should be reported in Mel’s gross income for the year?

1. $0
2. $1,200
3. $3,600
4. $4,800

Answer 26

D.

Since this is not an accountable plan, all reimbursements are included in the employee’s income ($400 x 12 months = $4,800). The employee business expenses of $3600 are no longer deductible.

Question 27

86. Taxation of Employee Benefits

Johnson worked for ABC Co. and earned a salary of $100,000. Johnson also received, as a fringe benefit, group term-life insurance at twice Johnson’s salary. The annual IRS-established uniform cost of insurance is $2.76 per $1,000. What amount must Johnson include in gross income?

1. $100,000
2. $100,276
3. $100,414
4. $100,552

Answer 27

C.

The first $50,000 of group-term life insurance provided by an employer is a tax-free fringe benefit. Johnson receives $200,000 of group-term life insurance, so $150,000 of this coverage of taxable. This response incorrectly taxes Johnson on only $100,000 of insurance coverage.

Question 28

86. Taxation of Employee Benefits

Under a “cafeteria plan” maintained by an employer,

1. Participation must be restricted to employees, and their spouses and minor children.
2. At least three years of service are required before an employee can participate in the plan.
3. Participants may select their own menu of benefits.
4. Provision may be made for deferred compensation other than 401(k) plans.

Answer 28

C.

Cafeteria plans allow employees to select from a menu of fringe benefits and cash and not include the value of the nontaxable benefits in their gross income. The requirements of cafeteria plans are:

1) all participants must be employees;
2) participants may choose between two or more benefits composed of cash or qualified benefits;
3) participants are required to make elections among the benefits;
4) the plan must be in writing and have certain specified information;
5) the plan may not provide participants with deferred income, except for under 401(k) plans.

A participant’s spouse and minor children may not be participants in a cafeteria plan. However, the plan may provide benefits for a participant’s spouse and minor children

Question 29

87. Taxation of Retirement Plans

I. Retirement Savings

Example

TP is a single taxpayer who has modified AGI of $65,000. This year (2019), TP is covered by a qualified pension plan, and he made a $6,000 contribution to an IRA. Because of the phase-out, TP loses 10% ($600) of the IRA deduction ([$65,000 − $64,000]/ $10,000). Hence, TP deducts $5,400 ($6,000 − $600) of the IRA contribution. The remaining $600 is a nondeductible contribution.

Answer 29

C. Traditional IRAs

1. Contributions—The limit on any IRA contribution (deductible or nondeductible) is $6,000 (2019), or compensation (an additional $1,000 catch-up contribution is allowed for taxpayers over the age of 50). Hence, for a married couple, the limit on IRA contributions is $12,000, or combined compensation. Excess contributions are subject to a 6% excise tax each year until withdrawn.
2. IRA deductions—If the taxpayer is not a participant in a qualified pension plan, the IRA contributions can be deducted for AGI. IRA contributions can also be deducted by taxpayers who are active participants in qualified plans, but this deduction is phased out proportionately over a $10,000 range ($20,000 if married filing jointly) if the taxpayer’s modified AGI exceeds the limit below. JNT: 103000 ~ 123000, SNG: 64000~74000

D. Roth IRA—Contributions are not deductible.

1. The limit on contributions to a Roth IRA is the same as those to a traditional IRA (compensation of $6,000, or $7,000 for those 50 or older [$12,000 if married filing jointly]) without consideration of the rule about participation in a qualified pension. The limit on Roth contributions is coordinated with other IRAs so that combined contributions to all IRAs cannot exceed these limits.
2. Covered contributions to a Roth IRA are phased out proportionately if the taxpayer’s modified AGI for 2019 exceeds $193,000 for married filing jointly (a $10,000 range) or $122,000 for single taxpayers (a $15,000 range).

Question 30

87. Taxation of Retirement Plans

II. Retirement Distributions

C. Distribution Rules from Qualified Plans

Example

Mr. Kitten purchased an annuity contract for $50,000 from the XYZ Company on March 31, Year 1. He is to receive $1,000 per month starting April 1, Year 1 and continuing for life. He has a life expectancy of 10 years as of March 31, Year 1. Mr. Kitten’s reportable annuity income for Year 1 is:

Cost of Annuity ($50,000) / Expected Return (120 months × $1,000 = $120,000) × Pmt. ($9,000) = $3,750

Includible Amount = $9,000 − $3,750 = $5,250

Answer 30

D. Tax on Excess Accumulations

1. Distributions from qualified plans must begin by the “required beginning date” and the payment each year must be at least equal to the required minimum distribution.
2. If the required distribution is not made, a tax equal to 50% of the required distribution not made must be paid.
3. The required beginning date is by April 1 of the later of:
   
   1. the year the taxpayer reaches age 70½ or
   2. the year the employee retires.

Question 31

87. Taxation of Retirement Plans

III. Special Retirement Plans—Self-employed taxpayers may make deductible contributions to special retirement plans.

Answer 31

1. Qualified plans for self-employed individuals are called Keogh or HR 10 plans. These plans have the same limits as pension plans, except the maximum percentage limit is based upon self-employment earnings. For 2019, contributions are limited to the lesser of $56,000 or 25% of earned income. Earned income equals net earnings from self-employment less 50% of the self-employment tax less the allowable Keogh contribution.
2. Section 457 plans may be offered by state and local governments and tax-exempt organizations. Employees may defer up to $19,000 in 2019.
3. A 401(k) plan allows voluntary employee contributions to reduce taxable salary up to a maximum of $19,000, plus $6,000 catch-up for those aged 50 and over (2019). A 403(b) plan is similar to a 401(k) plan but is offered by education institutions. The same limits apply for 403(b) plans.
4. A simplified employee pension (SEP) is a plan where the employer may contribute to a SEP-IRA for each employee. Contributions can be limited to employees who (a) are at least 21 years old, (b) have performed service for the employer during at least three of the last five years, and (c) have received compensation from the employer of at least $600 in 2019.
   
   1. Contributions can be discretionary, but must be a uniform percentage of compensation for each employee.
   2. Contributions must be 100% vested at all times.
   3. Contributions for 2019 to an employee’s SEP-IRA are excludable from the employee’s income to the extent they do not exceed the lesser of:
      
      1. 25% of the employee’s compensation; or
      2. $56,000.
   4. To take a deduction for contributions for a particular year, the contributions made for that year must be made by the due date (including extensions) of the employer’s income tax return for that year.

Question 32

87. Taxation of Retirement Plans

IV. Section 529 Plans

Answer 32

1. These plans are used to save for college expenses through a vehicle that allows the earnings to be excluded from gross income.
2. Contributions are not deductible, and a beneficiary must be specified for the plan. States typically allow lifetime contributions of as much as $250,000 to the plan.
3. Earnings in the plan are tax-deferred.
4. Distributions from the plans are excluded from income to the extent that the distribution is used to pay for tuition, fees, books, etc., and reasonable room and board costs. Distributions not used for a qualified purpose are subject to income taxation and a 10% penalty.
5. For distributions after 2017, qualified expenses include tuition at elementary or secondary public, private, or religious schools. This exclusion is limited to $10,000 per year.