Quiz 2
Which one of the following statements is incorrect regarding investment interest expense? A) Excess investment interest expense cannot be carried forward into succeeding tax years. B) Interest paid or accrued to purchase or carry tax-exempt investments is not deductible. C) Investment interest expense is deductible up to the amount of the net investment income. D) Net investment income is the taxpayer's investment income—typically interest, nonqualified dividends, and short-term capital gains.
A) Excess investment interest expense can be carried forward into succeeding tax years. Investment interest expense is deductible up to the amount of net investment income. The interest on funds borrowed to purchase tax-exempt investments is not deductible. The net investment income is typically interest, nonqualified dividends, and short-term capital gains. Long-term capital gains and qualified dividends may be included at the taxpayer's election, but the taxpayer must forgo the preferential tax rates on these items.
Tom Bell has investment income (interest) of $8,000 in the current year. He paid $1,200 in investment adviser fees and had $7,000 of investment interest expense. His AGI is $35,000. What amount of investment interest expense may be deducted in the current year as an itemized deduction? A) $7,000 B) $6,500 C) $6,800 D) $8,000
A) Investment interest expense is deductible up to the amount of investment income. The investment income is the interest income of $8,000. However, the deduction cannot exceed the actual investment interest expense of $7,000.
Your client Sally, age 30, is designing an educational investment program for her 8-year-old son. She expects to need the funds in about 10 years when her AGI will be approximately $70,000. She wants to invest at least part of the funds in tax-exempt securities. Which of the following investment(s) may yield tax-exempt interest on her federal return if the proceeds were used to finance her son's education? Treasury bills EE bonds GNMA funds Zero coupon Treasury bonds A) II only B) I, III, and IV C) III and IV D) II and III
A) Proceeds from EE savings bonds may be exempt if the proceeds are used for qualified higher-education expenses of the taxpayer, spouse, or dependent. There is an AGI phaseout, which is $91,850-$106,850 (2023) for a single taxpayer. (The actual phaseouts are provided on the exam.) All the other options generate currently taxable income. The Treasury bills and GNMA funds both produce taxable income on the federal return (Treasury bill interest would typically be tax exempt on her state return). The zero Treasury also produces taxable income each year as the amortized discount is added to taxable income, even though no cash income is received.
Which one of the following is NOT subject to the Medicare contribution tax? A) Qualified Roth distributions B) Income from a nonperiodic distribution from an annuity C) Long-term capital gains D) Qualified dividends
A) Qualified Roth distributions are not subject to the Medicare contribution tax. Only taxable items, such as net capital gains, net rental income, annuity income and dividends, for example, are subject to the Medicare contribution tax.
Matthew Brady, age 67, purchased a deferred annuity in January 1982 for $50,000. In the current year, when the surrender value was $125,000, Matthew took a nonperiodic distribution of $75,000. Which one of the following statements correctly describes the income tax consequences of the distribution? A) $50,000 is tax free, $25,000 is taxable. B) $75,000 is tax free. C) $75,000 is taxable income. D) $50,000 is taxable, $25,000 is tax free.
A) The pre-August 14, 1982, annuity retains first-in, first-out (FIFO) treatment. Thus, the basis of $50,000 is treated as being withdrawn first and is tax free. The remaining $25,000 is taxable. If this were a post-August 13, 1982, contract, it would be treated on a last-in, first-out (LIFO) basis.
Which one of the following is CORRECT regarding the Coverdell Education Savings Account? A) Distributions may be tax free even if made for K-12 expenses. B) Deductible contributions of up to $2,000 may be made per beneficiary. C) Distributions may be tax free only if made for a full-time student. D) Room and board may be covered with a tax-free distribution only if the student is full-time.
A) The predominant benefit of the Coverdell ESA is distributions may also be used to pay for K-12 expenses. This is unlike the 529 plan which is designed primarily to pay for college expenses (Note: a limited amount of $10,000 may now be withdrawn from a 529 for K-12 expenses).
Which of the following benefits that Claudia has received from her employer can be excluded from taxation? A) $5,000 of graduate education assistance. B) A company car that she uses for personal vacations. C) A year-end bonus. D) An athletic membership at a local club valued at $1,500 per year.
A) Undergraduate and graduate education assistance is excluded from an employee's income in any one year period, up to a maximum of $5,250. The other options are fully taxable.
Which of the following statements correctly defines inside buildup as it refers to life insurance? A) During the insured's lifetime, the accumulations of cash value within a policy grow on a tax-preferred basis. B) During the insured's lifetime, the accumulations of cash value within a policy grow on a tax-deferred basis. C) During the insured's lifetime, the accumulations of cash value within a policy grow on a tax-annuitized basis. D) During the insured's lifetime, the accumulations of cash value within a policy grow on a tax-free basis.
B) Accumulations of cash value within a life insurance policy grow on a tax-deferred basis during the insured's lifetime.
Several years ago, Allison Colbert purchased a deferred fixed annuity. The cost of the annuity was a single payment of $40,000. The annuity will provide monthly payments of $275. At the time the annuitized distributions are to begin, Allison's life expectancy will be 25 years. How much of each payment will be excluded from taxation? A) $142 B) $133 C) $57 D) $206
B) Allison is expected to receive $82,500 ($275 × 12 × 25). Her investment in the contract ($40,000) is then divided by the total expected return ($82,500) to determine the excludable portion of each payment. The exclusion ratio is the $40,000 divided by $82,500, which equals 48.48%. 48.48% of $275 = $133 excludable from each payment.
Bruce and Melissa Parish, married taxpayers filing jointly, have the following items related to their investments during the current tax year: Investment interest expense $5,000 Interest income $2,500 Short-term capital gains $1,000 Investment adviser's fees $1,250 Commissions paid on stock purchase $200 Adjusted gross income $60,000 What is the Parishes' allowable investment interest expense deduction for the current year? A) $5,000 B) $3,500 C) $3,250 D) $3,450
B) Investment interest expense is limited to the taxpayer's net investment income of $3,500.
Samantha received the following dividends in 2023 from her portfolio: Ordinary dividends from HOT stock, a publicly traded company Dividends from Sky High Realty and Trust, a publicly traded REIT Life insurance dividends from her whole life policy Qualified dividends from BET stock, a publicly traded company Which of the above is NOT considered taxable? A) II and IV B) III only C) IV only D) I and II
B) Life insurance dividends are considered a return of premium paid (provided the cumulative dividends received over the life of the policy do not exceed the basis in the policy) and thus are not taxable. The other choices listed are taxable. Qualified dividends are eligible for long term capital gains rates. REIT dividends may qualify for a QBI deduction but nonetheless will still be taxable.
Eight years ago, Joan Allen, a married taxpayer filing jointly, purchased U.S. Series EE savings bonds for $6,000. She titled the bonds jointly with her husband, Hank. During the current year, when Joan was 35 years old, they redeemed the bonds to help pay for Joan's graduate school tuition. The accrued value at the time of redemption was $8,000. Their AGI for 2023 is estimated to be $100,000. Assume Joan incurs $8,000 of tuition expenses during the year. What are the tax consequences upon the redemption of the bonds? A) The interest is taxable at both state and federal levels. B) All the interest may be excluded. C) A portion of the interest may be excluded. D) All accrued interest is taxable in the current year.
B) The EE bond exclusion (for educational purposes) is phased out (for married couples filing jointly) between $137,800 and $167,800 of AGI in 2023. There is no exclusion available when AGI exceeds $167,800. It is not necessary to memorize the exact phaseout amounts because they will be provided on the exam. To qualify for the exclusion, the bonds must be purchased by an individual age 24 or older and held in that person's name, or jointly with a spouse. EE bonds are not taxable at the state level.
Seven years ago, Karen Price purchased U.S. EE savings bonds for $5,000. During the current year, when Karen was 27 years old, she redeemed the bonds to help pay for her graduate school tuition. The accrued value at the time of redemption was $7,000. Assume Karen incurs $11,000 of tuition expenses in the year. What are the tax consequences upon the redemption of the bonds? A) The income on the bonds is generally subject to state income taxes. B) All accrued interest is taxable in the current year. C) A portion of the interest may be excluded. D) All the interest may be excluded.
B) The exclusion for EE bond interest redeemed to pay for qualifying higher-education expenses applies only to bonds purchased by an individual age 24 or older, and held in that person's name, or jointly with a spouse. Karen is 27 years old; the bonds were purchased 7 years ago, when Karen was approximately 20. Because Karen does not qualify for the exclusion of the interest income because she was not age 24 or older at the time of purchase. All the interest is taxable in the year the bonds are redeemed. Remember that the interest of EE bonds is deferred until maturity, unless an election has been made to have the interest taxed each year as it accrues. Also, the interest income from EE bonds (and other federal government obligations) is generally not subject to state income tax.
Adrian Brown owned 500 shares of XYZ growth and income fund. She has become increasingly dissatisfied with the performance of the fund and, upon the advice of a friend, decided to execute a "telephone transfer" and switch the balance in the fund to the XYZ intermediate bond fund. Which one of the following describes the tax effect of such a strategy? A) Any loss will be recognized by the taxpayer, but any gain will be deferred through a reduction in the basis of the new fund. B) No gain or loss will be recognized by the taxpayer, and the basis in the new fund will be the same as that of the old fund. C) Gain or loss will be recognized by the taxpayer on the redemption of the old fund. D) No gain or loss will be recognized by the taxpayer, but the basis of the new fund will be reduced by any deferred gain or increased by any unrecognized loss.
C) A telephone transfer is the same as a sale or other taxable redemption of the fund. Therefore, gain or loss will be recognized based on the difference in the redemption proceeds and the basis in the shares redeemed. This is true even if the transfer is made between two funds in the same fund family.
For the current tax year, Bob Phillips, an individual taxpayer filing a joint return, has $50,000 of investment interest expense and $20,000 of net investment income (interest and dividends). Bob's AGI is $200,000. How much investment interest expense, if any, may Bob deduct in the current tax year? A) $50,000 B) $0 C) $20,000 D) $21,000
C) Investment interest expense is deductible up to the amount of net investment income. The problem tells us that the net investment income is $20,000; thus that is the maximum deduction. The fact that the dividends are included in the net investment income indicates that the taxpayer elected to include them in investment income and is forgoing the preferential rates associated with qualified dividends. The AGI has no bearing on the answer.
Lindsey is age 2 and her total income was $2,500 in qualified dividends in 2023. What is the tax on the dividends at Lindsey's rate? A) $30 B) $95 C) $0 D) $115
C) Lindsey is in the 10% marginal income tax bracket. She can use the long-term capital gains tax rate on qualified dividends received. At her income and filing status, the capital gain tax rate is 0%.
Your client, Elaine Dell, is near the highest tax bracket and is contemplating several investments. She is, however, concerned about minimization of her federal income tax liability on the income from the investment. Which of the following investments would produce income that would be taxed at the lowest potential tax rate? A) A zero coupon bond B) A corporate bond fund C) A utility stock with a high dividend yield D) A certificate of deposit
C) Qualified dividends are generally taxed at a 15% rate (or 20% for taxpayers with higher income levels). All of the other options produce interest income, which is taxable as ordinary income, at the marginal rate of the taxpayer.
Clare is a single taxpayer. In 2023, her AGI is $235,000, including a net long-term capital gain of $50,000. What is the amount, if any, of Medicare contribution tax that she must pay? A) $570 B) $0 C) $1,330 D) $1,900
C) She will pay the 3.8% Medicare contribution tax on $35,000. This is the lesser of the net investment income ($50,000) or the AGI in excess of the threshold amount ($235,000 - $200,000, or $35,000). In this situation, only $35,000 of the net investment income is subject to the Medicare contribution tax. Clare will pay a $1,330 Medicare contribution tax (3.8% on $35,000).
Which of the following taxpayers may owe the additional Medicare tax of .9% in 2023? Brad and Jane file jointly and have combined wages of $288,000. Terry's only income in 2023 is from his investments and totals $290,000. Jack has earned $150,000 in compensation from his employment at Bland Foods Inc. Lisa, whose filing status is head of household, is self-employed and has self-employment income of $225,000. A) I only B) IV only C) I and IV D) I, II, and III
C) Statements I and IV are correct. The additional Medicare tax rate is .9%. An individual is liable for the additional Medicare tax if the individual taxpayer's wages, other compensation, or self-employment income (combined with a spouse if filing as married filing jointly) exceeds the thresholds for the taxpayer's filing status of a combined income greater than $200,000 if single/head-of-household or $250,000 if married filing jointly. Choice II is incorrect. Because Terry has no wage income, the Additional Medicare tax of .9% cannot apply. However, Terry is subject to the separate Net Investment Income tax of 3.8%.
Terry and Jan are married taxpayers filing a joint tax return. In 2023, their AGI is $310,000, and their net investment income (included in the AGI) is $90,000. What is the amount of their Medicare contribution tax for 2023? A) $3,420 B) $4,180 C) $2,280 D) $0
C) Terry and Jan will pay the 3.8% Medicare contribution tax on $60,000. This is the lesser of the net investment income ($90,000) or the AGI in excess of the threshold amount ($310,000 - $250,000, or $60,000). In this situation, only $60,000 of the net investment income is subject to the Medicare contribution tax and calculates to $2,280 ($60,000 × 0.038).
For two years, Lisa Carson was able to pay the premiums on her whole life policy without borrowing. For the past two years, she has borrowed from the cash value of her whole life policy to pay the premiums. Last year, she paid $95 of interest on the funds she borrowed. What are the tax implications in this situation? A) The interest expense is tax deductible because it does not exceed $100. B) The interest expense is not tax deductible because it does not exceed $100. C) The interest expense is not tax deductible. D) The interest is deductible because Lisa is in the business of continuing her insurance and the interest is deductible business interest expense.
C) The interest expense is not tax deductible because interest on a loan incurred to purchase personal life insurance protection is considered personal interest, which is not deductible. Personal loan interest is not tax deductible, regardless of whether the lender is a bank or a life insurance company.
Sheila, a single taxpayer, has taxable income of $520,000. Included in the taxable income is $50,000 of qualified dividends. At what rate(s) will her qualified dividends be taxed? A) 15% only B) 20% only C) 15% and 20% D) 25% only
C) The qualified dividends straddle the $492,300 breakpoint (for 2023). Thus, a portion fall into the $44,626 to $492,300 range and are taxed at 15%. The dividends above the $492,300 breakpoint are taxed at 20%.
Tim Jones is single, 21 years old, and in his third year of college. He has an AGI of $35,000 and receives no support from his parents. The college is a Title IV institution where students are eligible to receive federal financial aid, and Tim is pursuing an undergraduate degree in criminal justice. When Tim was 13, his parents established a Uniform Transfers to Minors Act (UTMA) for him, and funded it with EE savings bonds. When Tim was a freshman, he was convicted of a felony drug possession charge. Which one of the following is CORRECT regarding Tim's situation? A) Tim may redeem the EE bonds potentially tax free if the proceeds are used for his qualifying education expenses. B) Tim qualifies for the American Opportunity Tax Credit. C) Tim qualifies for the Lifetime Learning Credit. D) Tim could use both the American Opportunity Tax Credit and the Lifetime Learning Credit in the same year.
C) Tim qualifies for the Lifetime Learning Credit. His AGI is under the phaseout range. He is pursuing a degree at an eligible institution. The felony drug conviction would preclude the use of the American Opportunity Tax Credit but not the Lifetime Learning Credit. There is no exclusion available for EE bonds unless they are held by the individual who purchases the bonds or unless they are held jointly with a spouse. A bond that has been gifted to another taxpayer does not qualify for the exclusion. The American Opportunity Tax Credit and the Lifetime Learning Credit may not be claimed in the same year for the same student.
Which one of the following is a characteristic of a fixed annuity contract? A) The buyer may choose among a handful of investment options. B) The annuitant pays now for future fixed or variable payments. C) If a corporation owns the annuity contract, the earnings are not tax deferred. D) Fixed annuity contracts are not tax advantaged, unlike other annuity contracts.
C) With a fixed annuity contract, there is no ability to select the investment options; the payments are fixed. Fixed annuity contracts are generally tax advantaged (tax deferred), unless a corporation owns the annuity contract, in which case the earnings are currently taxable. Such is also the case with a variable annuity.
Cash value life insurance is often structured like an investment vehicle. However cash value life insurance contains important features that shelter the inside buildup from taxation. Which of the following will NOT be considered when determining whether a policy can maintain its tax favored status? A) The cash value accumulation test B) The death benefit C) The earned premium test D) The guideline premium and corridor test
C) Without a death benefit, a contract does not meet the legal definition of life insurance. There are currently two tests—only one of which must be met—in order to classify a product as life insurance for federal income tax purposes: (1) the cash value accumulation test and (2) the guideline premium and corridor test. There is no earned premium test.
In 1992, John Idler purchased a single premium whole life insurance policy. In the current year his medical expenses are $15,000 and his AGI is $75,000. What is the tax implication to John if he borrows the interest from the policy's accumulated cash value to pay his current year's medical expenses? A) John will not be required to report the amount borrowed as income and will not be allowed a medical expense deduction. B) John will be required to report the amount borrowed as income, but he will not be allowed a medical expense deduction. C) John will not be required to report the amount borrowed as income, but he will be allowed a medical expense deduction. D) John will be required to report the amount borrowed as income and will be allowed a medical expense deduction.
D) Amounts borrowed on a single premium whole life policy issued on or after June 21, 1988 (a MEC), are taxable on a last-in, first-out basis; thus, the earnings would be taxable. A medical expense deduction will be allowed regardless of the source of the funds, since the payment would be for a valid medical expense.
Which one of the following statements is CORRECT concerning capital gains and losses? A) Net capital gains are always taxed at a flat rate of 15%. B) Excess capital losses are carried forward for up to five years. C) Net capital gains are always taxed at a maximum rate of 28%. D) Net capital losses are deductible up to $3,000 annually.
D) Net long-term capital gains (LTCG) (from other than unrecaptured Section 1250 income and collectibles) are taxed at rates of 0%, 15%, or 20%. For married couples filing jointly, the 0% long-term capital gain rate ends at $89,250 of taxable income. For long-term capital gains falling between the $89,250 breakpoint and $553,850 of taxable income (again, for married couples filing jointly), the rate is 15%. For long-term capital gains falling into taxable income levels above $553,850 (MFJ), the rate is 20%. The table shows the breakpoints for LTCG and qualified dividend preferential rates. LTCG Rates Based on Taxable Income Filing Status, 0% rate, 15% rate, 20% rate Single, Under $44,625, $44,626-$492,300, Over $492,300 Head of household, Under $59,750, $59,751-$523,050, Over $523,050 Married filing jointly, Under $89,250, $89,251-$553,850, Over $553,850 Estates and trusts, Under $3,000, $3,001-$14,650, Over $14,650 Special rates apply to the sale of real estate or collectibles—25% (the maximum rate for gain attributable to straight-line depreciation on real estate), or 28% (maximum rate in the case of collectibles). Net capital losses, the capital losses remaining after netting against capital gains, are deductible up to $3,000 per year with an indefinite carryforward.
Michelle Will has interest income of $23,000 in the current tax year. She paid brokers' commissions of $2,000 on stock purchases and had $40,000 of investment interest expense. What amount, if any, of investment interest expense may be deducted as an itemized deduction? A) $33,000 B) $21,000 C) $0 D) $23,000
D) The deduction for investment interest expense ($40,000) is limited to net investment income ($23,000). The remaining portion ($17,000), however, can be carried forward into future years. Note that the broker's commissions are not deductible, nor considered an expense when calculating net investment income.
Which of the following statements regarding the use of life insurance inside a retirement plan is CORRECT? A) The premiums paid are a taxable benefit to the employer. B) If the employee dies prematurely, the survivors will receive no benefits. C) The premiums paid are NOT a taxable benefit to the employee. D) The premiums paid are a taxable benefit to the employee.
D) The premiums paid are a taxable benefit to the employee. The main benefit to the employee is in the event of their premature demise, their survivors will still receive ample retirement benefits.
Ann Hamilton owns 500 shares in the XYZ S&P 500 Index Fund. The basis of her investment in this fund is $4,500, while the fair market value is only $2,000. She wants to sell her shares to "lock in" the $2,500 loss, but she is considering buying 500 shares of the GRC Small-Cap Index ETF the following week because she believes that the value is going to increase significantly over a longer period. As her planner, what can you accurately tell Ann about this scenario? A) She should wait a minimum of 61 days after the sale to repurchase the shares so that the loss may be recognized. B) The basis in the newly acquired shares would be the amount paid for those shares, increased by the $2,500 disallowed loss. C) If the loss were disallowed, the basis in the newly acquired shares would be decreased by the disallowed loss. D) The loss would be a fully deductible capital loss.
D) The wash sale rule disallows a loss if substantially identical securities are purchased prior to 30 days after the sale that resulted in the loss. The basis of the acquired securities is increased by the amount of the disallowed loss. The S&P 500 mutual fund should not be substantially identical to the small-cap ETF because the funds track very different indices and because of the difference in the way ETFs trade compared with mutual funds.
