Chapter 13 Personal Income Tax

60. Which of the following statements concerning traditional IRAs and Roth IRAs is true? A. A taxpayer may contribute to a Roth IRA at any age but a taxpayer is not allowed to contribute to a traditional IRA after reaching 70½ years of age. B. The annual contribution limits for a traditional IRA and Roth IRA are the same. C. Taxpayers with high income are allowed to contribute to traditional IRAs but not to Roth IRAs. D. All of these are true statements.

D

57. Lisa, age 45, needed some cash so she received a $50,000 distribution from her Roth IRA. At the time of the distribution, the balance in the Roth IRA was $200,000. Lisa established the Roth IRA 10 years ago. Over the years, she has contributed $20,000 to her account. What amount of the distribution is taxable and subject to early distribution penalty? A. $0 B. $5,000 C. $30,000 D. $50,000

C Because this is a nonqualifying distribution, Lisa is taxed and penalized to the extent the distribution exceeds her contributions to the account. In this case, the excess is $30,000 ($50,000 distribution minus $20,000 contributions).

21. Taxpayers who participate in an employer-sponsored retirement plan are not allowed to deduct contributions to individual retirement accounts (IRAs) under any circumstances.

FALSE

8. When an employer matches an employee's contribution to the employee's 401(k) account, the employee is immediately taxed on the amount of the employer's matching contribution.

FALSE

5. Distributions from defined benefit plans are taxed as long-term capital gains to beneficiaries.

FALSE - Distributions are taxable as ordinary income in the year received.

13. An employer may contribute to an employee's traditional 401(k) account but the employer may not contribute to an employee's Roth 401(k) account.

TRUE

28. Which of the following statements is true regarding employer-provided qualified retirement plans? A. May discriminate against rank and file employees. B. Deductible contributions are generally phased-out based on AGI. C. Executives are generally ineligible to participate in these plans. D. They are generally referred to as defined benefit plans or defined contribution plans.

D

42. Shauna received a $100,000 distribution from her 401(k) account this year. Assuming Shauna's marginal tax rate is 25%, what is the total amount of tax and penalty Shauna will be required to pay if she receives the distribution on her 59th birthday and she has not yet retired? A. $0. B. $10,000. C. $25,000. D. $35,000. E. None of these.

D She must pay $25,000 of income tax on the distribution and a 10% early distribution penalty because she was not 59½ on the date of the distribution and she had not yet retired.

31. Which of the following statements regarding vesting in a defined benefit plan is correct? A. Under a cliff vesting schedule, a portion of an employee's benefits vest each year. B. Under a graded vesting schedule, an employee's entire benefit vests all at the same time. C. When an employee's benefits vest, she is entitled to participate in the employer's defined benefit plan. D. When an employee's benefits vest, she is legally entitled to receive the benefits.

D To vest in a benefit means to be legally entitled to receive it.

7. Both employers and employees may contribute to defined contribution plans. However, the amount that employees may contribute to the plan in a given year is limited by the tax law while the amount that employers may contribute is not.

FALSE - For 2015, the sum of employer and employee contributions to an employee's defined contribution account is limited to the lesser of: • $53,000 ($59,000 for employees who are at least 50 years of age by the end of the year); or • 100% of the employee's compensation for the year.

11. Retired taxpayers over 59½ years of age at the end of the year must receive minimum distributions from defined contribution plans or they are subject to a penalty.

FALSE - Minimum distributions are required for the year in which an employee reaches 70½ years of age or retires, whichever comes later.

14. Employee contributions to traditional 401(k) accounts are deductible by the employee, but employee contributions to Roth 401(k) accounts are not.

TRUE

16. Just like distributions from qualified retirement plans, distributions from nonqualified deferred compensation plans are taxed as ordinary income to the recipient.

TRUE

17. Participating in an employer-sponsored nonqualified deferred compensation plan is potentially risky because employers are not required to fund nonqualified plans. If the employer is not able to pay the employee when the payment is due, the employee usually becomes an unsecured creditor of the employer.

TRUE

19. Employers may choose whom they allow to participate and whom they do not allow to participate in their nonqualified deferred compensation plans.

TRUE

2. Defined benefit plans specify the amount of benefit an employee will receive on retirement while defined contribution plans specify the amounts that employers and employees will (or can) contribute to an employee's plan.

TRUE

25. A SEP IRA is an example of a self-employed retirement account.

TRUE

46. Which of the following statements regarding Roth 401(k) accounts is false? A. Employees can make contributions to a Roth 401(k). B. Employers can make contributions to Roth accounts on behalf of their employees. C. Contributions to Roth 401(k) plans are not deductible. D. Qualified distributions from Roth 401(k) plans are not taxable.

B An employer is not allowed to contribute to an employee's Roth 401(k) account.

54. Bryan, who is 45 years old, had some surprise medical expenses during the year. To pay for these expenses (which were claimed as itemized deductions on his tax return), he received a $20,000 distribution from his traditional IRA (he has only made deductible contributions to the IRA). Assuming his marginal ordinary income tax rate is 15%, what amount of taxes and/or early distribution penalties will Bryan be required to pay on this distribution? A. $3,000 income tax; $2,000 early distribution penalty B. $3,000 income tax; $0 early distribution penalty C. $0 income tax; $2,000 early distribution penalty D. $0 income tax; $0 early distribution penalty

B Because the IRA distribution was used for qualified medical expenses it is not subject to the 10 percent early distribution penalty but the full amount of the distribution is subject to the regular income tax ($20,000 × 15%).

38. When employees contribute to a traditional 401(k) plan, they _____ allowed to deduct the contributions and they ______ taxed on distributions from the plan. A. are, are not B. are, are C. are not, are D. are not, are not

B Contributions to a traditional 401(k) plan are deductible and distributions from the plan are fully taxable.

35. Which of the following describes a defined contribution plan? A. Provides guaranteed income on retirement to plan participants. B. Employers and employees generally may contribute to the plan. C. Generally set up to defer income for executives and highly compensated employees but not other employees. D. Retirement account set up to provide an individual a fixed amount of income on retirement.

B Employers and employees generally contribute to the plan.

27. High-income taxpayers are not allowed to receive the saver's credit.

TRUE

36. Which of the following statements regarding defined contribution plans is false? A. Employers bear investment risk relating to the plan. B. Employees immediately vest in their contributions to the plan. C. Employers typically match employee contributions to the plan to some extent. D. An employer's vesting schedule is used for employers' contributions in determining the amount of the plan benefits the employee is entitled to receive on retirement.

A Employees, not employers, bear the investment risk associated with the plan.

29. Which of the following describes a defined benefit plan? A. Provides fixed income to the plan participants based on a formula B. Distribution amounts determined by employee and employer contributions C. Allows executives to defer income for a period of years D. Retirement account set up by an individual

A Defined benefit plans pay a fixed income or benefit to the employee. This amount is usually based on the average income of the employee and the years of service. These plans are set up and funded by employers for employees.

64. Kathy is 60 years of age and self-employed. During the year she reported $400,000 of revenues and $100,000 of expenses relating to her self-employment activities. If Kathy has no other retirement accounts in her name, what is the maximum amount she can contribute this year to a simplified employee pension (SEP) IRA? A. $52,000 B. $56,500 C. $57,746 D. $288,933

A Her maximum contribution is the lesser of (1) $52,000 or (2) $57,746 [20% × ($300,000 - [((300,000 × .9235 - 117,000) × 2.9% × 50%) + (117,000 × .153 × 50%)]].

50. Which of the following statements concerning nonqualified deferred compensation plans is true? A. If an employer doesn't have the funds to pay the employee, the employee becomes an unsecured creditor of the employer. B. These plans can be an important tax planning tool for employers if they expect their marginal tax rate to decrease over time. C. These plans can be an important tax planning tool for employees who expect their marginal tax rate to increase over time. D. Distributions are taxed at the same tax rate as long-term capital gains.

A See discussion on nonqualified deferred compensation plans in text.

58. Tyson (48 years old) owns a traditional IRA with a current balance of $50,000. The balance consists of $30,000 of deductible contributions and $20,000 of account earnings. Convinced that his marginal tax rate will increase in the future, Tyson receives a distribution of the entire $50,000 balance of his traditional IRA and he immediately contributes the $50,000 to a Roth IRA. Assuming his marginal tax rate is 25%, what amount of penalty, if any, must Tyson pay on the distribution from the traditional IRA? A. $0. B. $1,250. C. $3,750. D. $5,000.

A The distribution from the traditional IRA is fully taxable but is not subject to penalty because Tyson contributed the full $50,000 to a Roth IRA within 60 days from the time of withdrawal.

34. Which of the following best describes distributions from a defined benefit plan? A. Distributions from defined benefit plans are fully taxable as ordinary income. B. Distributions from defined benefit plans are partially taxable as ordinary income and partially nontaxable as a return of capital. C. Distributions from defined benefit plans are fully taxable as capital gains. D. Distributions from defined benefit plans are partially taxable as capital gains and partially nontaxable as a return of capital.

A The full amount of distributions from defined benefit plans is taxable as ordinary income.

40. Which of the following best describes distributions from a traditional defined contribution plan? A. Distributions from defined contribution plans are fully taxable as ordinary income. B. Distributions from defined contribution plans are partially taxable as ordinary income and partially nontaxable as a return of capital. C. Distributions from defined contribution plans are fully taxable as capital gains. D. Distributions from defined contribution plans are partially taxable as capital gains and partially nontaxable as a return of capital.

A The full amount of distributions from defined contribution plans is taxable as ordinary income.

41. Shauna received a distribution from her 401(k) account this year. In which of the following situations will Shauna be subject to an early distribution penalty? A. Shauna is 60 years of age but not yet retired when she receives the distribution. B. Shauna is 58 years of age but not yet retired when she receives the distribution. C. Shauna is 56 years of age and retired when she receives the distribution. D. Shauna is 69 years of age but not yet retired when she receives the distribution.

B Taxpayers are subject to an early distribution penalty if they receive a distribution before they reach 59½ and are not retired, or have retired but not reached 55 years of age.

59. Tyson (48 years old) owns a traditional IRA with a current balance of $50,000. The balance consists of $30,000 of deductible contributions and $20,000 of account earnings. Tyson's marginal tax rate is 25%. Convinced that his marginal tax rate will increase in the future, Tyson receives a distribution of the entire $50,000 balance of his traditional IRA. He retains $12,500 to pay tax on the distribution and he contributes $37,500 to a Roth IRA. What amount of income tax and penalty must Tyson pay on this series of transactions? A. $0 income tax; $0 penalty. B. $12,500 income tax; $1,250 penalty. C. $12,500 income tax; $3,000 penalty. D. $12,500 income tax; $5,000 penalty.

B The distribution from the traditional IRA is fully taxable ($50,000 × 25%). Tyson must pay a 10% penalty on the portion of the distribution that he did not contribute to a Roth IRA ($12,500 × 10%).

65. Which of the following taxpayers is most likely to qualify for the saver's credit? A. A low AGI taxpayer who does not contribute to any qualified retirement plan. B. A low AGI taxpayer who contributes to her employer's 401(k) plan. C. A high AGI self-employed taxpayer. D. A high AGI employee who does not contribute to any qualified retirement plan.

B To be eligible for the saver's credit a taxpayer must contribute to a qualified retirement plan (including IRAs). Further, the credit is phased out completely for high AGI taxpayers.

66. Amy is single. During 2015, she determined her adjusted gross income was $12,000. During the year, Amy also contributed $2,500 to a Roth IRA. What is the maximum saver's credit she may claim for the year? A. $1,250 B. $2,500 C. $1,000 D. $0

C $2,000 × 50% (the maximum contribution eligible for the credit multiplied by the maximum applicable percentage based on filing status and AGI).

32. Dean has earned $70,000 annually for the past five years working as an architect for MWC Inc. Under MWC's defined benefit plan (which uses a 7-year graded vesting schedule) employees earn a benefit equal to 3.5% of the average of their three highest annual salaries for every full year of service with MWC. Dean has worked for five full years for MWC and his vesting percentage is 60%. What is Dean's vested benefit (or annual retirement benefit he has earned so far)? A. $12,250 B. $42,000 C. $7,350 D. $0

C $7,350: $70,000 (average salary for the prior three years) × 17.5% (3.5% × 5 years of service) × 60% (vesting percentage).

56. Which of the following statements regarding Roth IRAs distributions is true? A. A distribution is not a qualifying distribution unless the distribution is at least two years after the taxpayer has opened the Roth IRA. B. A taxpayer receiving a distribution from a Roth IRA before reaching the age of 55 is generally not subject to an early distribution penalty. C. A Roth IRA does not have minimum distribution requirements. D. The full amount of all nonqualifying distributions is subject to tax at the taxpayer's marginal tax rate.

C A Roth IRA does not have minimum distribution requirements. A nonqualifying distribution is not subject to tax to the extent it is from the taxpayer's contributions to the account.

47. Which of the following statements is true regarding distributions from Roth 401(k) accounts? A. There are no minimum distribution requirements for distributions from Roth 401(k) accounts. B. Qualified distributions are subject to taxation. C. A taxpayer receiving a nonqualified distribution from a Roth 401(k) account may be taxed on a portion but not all of the distribution. D. None of these is a true statement.

C A portion of nonqualified distributions is generally taxable and a portion is generally nontaxable. The nontaxable portion is determined by the ratio of contributions to the total value of the account.

30. Which of the following statements regarding defined benefit plans is false? A. The benefits are based on a fixed formula B. The vesting period can be based on a graded or cliff schedule C. Employees bear the investment risks of the plan D. Employers are generally required to make annual contributions to meet expected future liabilities

C Employees do not bear the risk of the plan's investment.

63. Which of the following statements concerning individual 401(k)s is false? A. In general, individual 401(k)s have higher administrative costs than SEP IRAs. B. Employees cannot participate in individual 401(k)s. C. Individual 401(k)s are available only to self-employed taxpayers with 100 or fewer employees. D. Individual 401(k)s have contribution limitations.

C Individual 401(k)s are strictly for self-employed individuals who do not have employees.

61. Which of the following statements regarding self-employed retirement accounts is true? A. A self-employed taxpayer who has hired employees may not set up a SEP IRA. B. A self-employed taxpayer who has hired employees may set up either a SEP IRA or an individual 401(k). C. A self-employed taxpayer who has hired employees may not set up an individual 401(k). D. All of these statements are false.

C See discussion of nontax factors of self-employed retirement accounts in text.

52. During 2015 Jacob, a 19 year old full-time student, earned $4,500 during the year and was not eligible to participate in an employer-sponsored retirement plan. The general limit for deductible contributions during 2015 is $5,500. How much of a tax-deductible contribution can Jacob make to an IRA? A. $0 (Full-time students are not allowed to participate in IRAs) B. $500 C. $4,500 D. $5,500

C Tax deductible contributions are limited to the lesser of $5,500 or the amount of earned income.

44. Riley participates in his employer's 401(k) plan. He turns 69 years of age on February 15, 2015, and he plans on retiring on July 1, 2015. When must Riley receive his first distribution from the plan to avoid minimum distribution penalties? A. by April 1, 2015 B. by April 1, 2016 C. by April 1, 2017 D. by April 1, 2018

C To avoid minimum distribution penalties, the taxpayer must receive the first distribution by no later than April 1 of the year after the employee turns 70½ or the year after the year in which employee retires (if later). Because Riley turns 70½ years of age in 2015, he must receive his first distribution no later than April 1, 2017 to avoid minimum distribution penalties.

33. Dean has earned $70,000 annually for the past 4½ years working as an architect for MWC. Under MWC's defined benefit plan (which uses a 5-year cliff vesting schedule) employees earn a benefit equal to 3.5% of the average of their three highest annual salaries for every full year of service with MWC. What is Dean's vested benefit (or annual benefit he has earned so far)? A. $12,250 B. $42,000 C. $7,350 D. $0

D $0: To vest under a 5 year cliff vesting schedule, the employee must have completed five full years of service with the employer. With a cliff vesting schedule the employee is either 100% vested or 0% vested.

55. In 2015, Jessica retired at the age of 65. The current balance in her traditional IRA was $200,000. Over the years, Jessica had made $20,000 of nondeductible contributions and $60,000 of deductible contributions to the account. If Jessica receives a $50,000 distribution from the IRA, what amount of the distribution is taxable? A. $0 B. $5,000 C. $37,500 D. $45,000 E. $50,000

D 10% of the distribution is not taxable ($20,000 nondeductible contributions divided by balance in account of $200,000). Taxable portion is 90% so taxable amount is $45,000 ($50,000 × 90%).

45. Which of the following statements is true regarding taxpayers receiving distributions from traditional defined contribution plans? A. A taxpayer who retires at age 71 in 2015 is required to pay a minimum distribution penalty if she does not receive a distribution in 2015. B. The minimum distribution penalty is 30% of the amount required to have been distributed. C. A taxpayer who receives a distribution from a retirement account before she is 55 years old is subject to a 10% penalty on both the distributed and undistributed portions of her retirement account. D. Taxpayers are not allowed to deduct either early distribution penalties or minimum distribution penalties.

D Early distribution and minimum distribution penalties are not tax deductible.

51. Which of the following statements comparing qualified defined contribution plans and nonqualified deferred compensation plans is false? A. Employers must fund qualified defined contribution plans but not nonqualified deferred compensation plans. B. Qualified defined contribution plans are subject to formal vesting requirements while nonqualified deferred compensation plans are not. C. Distributions from both types of plans are taxed at ordinary income tax rates. D. In terms of tax consequences to the employee, earnings on qualified plans (except Roth plans) are deferred until distributed to the employee but earnings on nonqualified plans are immediately taxable.

D Employees are not taxed on nonqualified deferred compensation plans until they receive distributions from the plans.

39. When employees contribute to a Roth 401(k) account, they _____ allowed to deduct the contributions and they _______ taxed on distributions from the plan. A. are, are not B. are, are C. are not, are D. are not, are not

D Employees do not deduct contributions to Roth 401(k) accounts and they are not taxed on distributions from the plans.

48. Heidi has contributed $20,000 in total to her Roth 401(k) account over a six year period. In 2015, when her account was worth $50,000 and Heidi was in desperate need of cash, Heidi received a $30,000 nonqualified distribution from the account. How much of the distribution will be subject to income tax and 10% penalty? A. $0 B. $10,000 C. $12,000 D. $18,000 E. $30,000

D Heidi is not taxed on 40% of the distribution because this is considered a return of her nondeductible contribution. The 40% is the amount of her contributions divided by the value of the account ($20,000/$50,000). The remaining 60% ($18,000) is subject to tax and penalties.

53. Which of the following statements regarding IRAs is false? A. Taxpayers who participate in an employer-sponsored retirement plan may be allowed to make deductible contributions to a traditional IRA. B. The ability to make deductible contributions to a traditional IRA and nondeductible contributions to a Roth IRA may be subject to phase-out based on AGI. C. A taxpayer may contribute to a traditional IRA in 2015 but deduct the contribution in 2014. D. Taxpayers who have made nondeductible contributions to a traditional IRA are taxed on the full proceeds when they receive distributions from the IRA.

D If taxpayers make nondeductible contributions to a traditional IRA, they are taxed on only a portion of any distributions received. That is, the distribution is split into an income portion and a nontaxable return of capital portion.

62. Which of the following is true concerning SEP IRAs? A. SEP IRAs are difficult to set up and have high administrative costs B. Taxpayers may contribute unlimited amounts to SEP IRAs C. Employees of the taxpayer cannot be included in SEP IRAs D. Taxpayers with a SEP IRA must contribute for their employees

D See discussion of SEP IRAs in text.

49. Which of the following is true concerning employer funding of nonqualified deferred compensation plans? A. Employers are required to invest salary deferred by employees in investments specified by the employees. B. Employers are required to annually fund their deferred compensation obligations to employees. C. Employers annually deduct the amount earned by employees under the plan. D. Employers may discriminate in terms of who they allow to participate in the plan.

D See discussion of nonqualified deferred compensation plans in the text.

37. Which of the following statements regarding contributions to defined contribution plans is true? A. Employer contributions to a defined contribution plan are not limited by the tax law. B. Employee contributions to a defined contribution plan are not limited by the tax law. C. An employee who is at least 60 years of age as of the end of the year may contribute more to a defined contribution plan than an employee who has not reached age 60 by year end. D. The tax laws limit the sum of the employer and employee contributions to a defined contribution plan.

D The sum of employer and employee contributions is limited by the tax law. The limit is indexed for inflation.

43. Riley participates in his employer's 401(k) plan. He turns 70 years of age on February 15, 2013 and he plans on retiring on July 1, 2015. When must Riley receive his first distribution from the plan to avoid minimum distribution penalties? A. by April 1, 2013 B. by April 1, 2014 C. by April 1, 2015 D. by April 1, 2016

D To avoid minimum distribution penalties, the taxpayer must receive the first distribution by no later than April 1 of the year after which the employee turns 70½ or the year in which the employee retires (if later). Because Riley turns 70½ years of age in 2013, but does not retire until 2015, he must receive his first distribution no later than April 1, 2016 to avoid minimum distribution penalties.

10. Heidi retired from GE (her employer) at age 56. At the end of the year, when she was 56 years of age, Heidi received a distribution from her GE sponsored 401(k) account. Because Heidi was not at least 59½ years of age at the time of the distribution, she must pay tax on the full amount of the distribution and a 10 percent penalty on the full amount of the distribution.

FALSE - The penalty is assessed on employees who receive distributions before they reach 59½ years of age or 55 years of age and have separated from service (retired).

6. Taxpayers withdrawing funds from an IRA before they turn 70½ are generally subject to a 10 percent penalty on the amount of the withdrawal.

FALSE - The penalty is assessed on employees who receive distributions before they reach 59½ years of age or 55 years of age and have separated from service (retired).

23. Taxpayers never pay tax on the earnings of a traditional 401(k) account.

FALSE - all distributions from a traditional 401(k) account are taxed as ordinary income.

18. From a tax perspective, participating in a nonqualified deferred compensation plan is an effective tax planning strategy when the employee anticipates that her marginal tax rate will be higher when she receives the deferred compensation than when she defers the compensation.

FALSE - just the opposite is true. Deferring salary to a future period is potentially an effective tax planning technique, particularly when the employee anticipates his marginal tax rate to be lower in the year he will receive the deferred compensation than it is in the year he defers the salary.

24. Qualifying distributions from traditional IRAs are nontaxable while qualifying distributions from Roth IRAs are fully taxable as ordinary income.

FALSE - just the opposite is true. Qualifying distributions from Roth IRAs are nontaxable while qualifying distributions from traditional IRAs are fully taxable as ordinary income.

1. Qualified retirement plans include defined benefit plans but not defined contribution plans.

FALSE - qualified retirement plans include both defined benefit plans and defined contribution plans.

15. When a taxpayer receives a nonqualified distribution from a Roth 401(k) account the taxpayer contributions are deemed to be distributed first. If the amount of the distribution exceeds the taxpayer contributions, the remainder is from the account earnings.

FALSE - see problem #48.

20. Taxpayers who participate in an employer-sponsored retirement plan are not allowed to contribute to individual retirement accounts (IRAs).

FALSE - the IRA deduction is phased-out based on the taxpayer's AGI.

3. The standard retirement benefit an employee will receive under a defined benefit plan depends on the number of years of service the employee provides, but does not consider the amount of the employee's compensation near retirement.

FALSE - the retirement benefit is based on both years of service and the employee's compensation level at retirement.

22. Darren is eligible to contribute to a traditional 401(k) in 2015. He forgot to contribute before year end. If he contributes before April 15, 2016, he is allowed to treat the contribution as though he made it during 2015.

TRUE

26. A taxpayer can only receive a saver's credit if she contributes to a qualified retirement account.

TRUE

4. Jacob participates in his employer's defined benefit plan. He has worked for his employer for four full years. If his employer uses a five-year cliff vesting schedule, Jacob will need to work another year in order to vest in any of his defined benefit plan retirement benefits.

TRUE

9. Employees who are at least 50 years old at the end of the year are allowed to contribute more to their 401(k) accounts than employees who are not 50 years old by year end.

TRUE

12. On December 1, 2015 Irene turned 71 years old. She is still working for her employer and she participates in her employer's 401(k) plan. Irene is not required to receive a minimum distribution for 2015 from her 401(k) account because she has not yet retired.

TRUE - Minimum distributions are required by April 1 of the later of (1) the year after the year in which the employee turns 70½ or (2) the year after the year the employee retires.