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Chapter 3

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Chapter 3

  1. 1. Income Tax Fundamentals 2010 edition Gerald E. Whittenburg Martha Altus-Buller 2010 Cengage Learning
  2. 2. <ul><li>Net Rental Income/Loss is part of gross income </li></ul><ul><ul><li>Report on Schedule E - Part I </li></ul></ul><ul><li>Vacation Homes </li></ul><ul><ul><li>If both personal and rental use of residence, must allocate expenses </li></ul></ul><ul><ul><li>Deductions limited based on period of time residence used for personal vs. rental </li></ul></ul>2010 Cengage Learning
  3. 3. <ul><li>Three Categories – different tax treatment for each </li></ul><ul><ul><li>Category I: Primarily personal use </li></ul></ul><ul><ul><ul><li>Rented for less than 15 days </li></ul></ul></ul><ul><ul><li>Category II: Primarily rental use </li></ul></ul><ul><ul><ul><li>Rented more than or equal to 15 days and personal use does not exceed greater of 14 days or 10% of rental days </li></ul></ul></ul><ul><ul><li>Category III: Rental/personal (dual use) of property </li></ul></ul><ul><ul><ul><li>Rented more than or equal to 15 days and personal use exceeds greater of 14 days or 10% of rental days </li></ul></ul></ul><ul><ul><ul><li>See following screens for tax treatment for each scenario </li></ul></ul></ul>2010 Cengage Learning
  4. 4. <ul><li>Treated as a personal residence </li></ul><ul><li>Rental period is disregarded </li></ul><ul><ul><li>Rental income is not taxable </li></ul></ul><ul><ul><li>Mortgage interest/taxes reported on Schedule A (itemized deductions) </li></ul></ul><ul><ul><li>Other expenses are personal and nondeductible </li></ul></ul>2010 Cengage Learning
  5. 5. <ul><li>Must allocate expenses between rental and personal use – calculated as follows: </li></ul><ul><ul><li>Rental days / Total days used = Rental % </li></ul></ul><ul><ul><li>Expenses x Rental % = Rental deductions </li></ul></ul><ul><ul><li>Personal days / Total days used = Personal % </li></ul></ul><ul><li>If rental deductions exceed rental income, can deduct against other income, subject to passive loss rules </li></ul><ul><li>Personal % of mortgage interest & real estate taxes reported on Schedule A </li></ul>2010 Cengage Learning
  6. 6. <ul><li>Allocate expenses between rental and personal based on same allocation formulas as prior screen </li></ul><ul><li>Rental deductions can be taken up to amount of rental income only , in order , as follows </li></ul><ul><ul><li>Taxes and interest ( can take into loss situation) </li></ul></ul><ul><ul><li>Utilities/maintenance (only up to remaining rental income) </li></ul></ul><ul><ul><li>Depreciation (only up to remaining rental income) </li></ul></ul><ul><li>Personal % of mortgage interest & real estate taxes reported on Schedule A </li></ul>2010 Cengage Learning
  7. 7. <ul><li>Example </li></ul><ul><li>The Prebena family owns a ski condo in Alta, UT; in the current year personal use = 25 days and rental use = 50 days. Data pertaining to the rental follows; what amounts will be reported on Schedules E and A for the current year? </li></ul><ul><li>Rental income $10,000 </li></ul><ul><li>Taxes $ 1,500 </li></ul><ul><li>Interest $ 3,000 </li></ul><ul><li>Utilities $ 2,000 </li></ul><ul><li>Insurance $ 1,500 </li></ul><ul><li>Snow removal $ 2,500 </li></ul><ul><li>Depreciation $12,000 </li></ul>2010 Cengage Learning
  8. 8. 2010 Cengage Learning Example The Prebena family owns a ski condo in Alta, UT; in the current year personal use = 25 days and rental use = 50 days. Data pertaining to the rental follows; what amounts will be reported on Schedules E and A for the current year? Rental income $10,000 Taxes $ 1,500 Interest $ 3,000 Utilities $ 2,000 Insurance $ 1,500 Snow removal $ 2,500 Depreciation $12,000 Solution Step 1: Personal use is > 14 days or 10% of rental (5 days); therefore, does exceed the greater number and this is dual use property Step 2: Taxes/interest = $4,500 x 50/75 = $3,000 deduction on E Step 3: Other expenses = $6,000 x 50/75 = $4,000 deduction on E Step 4: Depreciation = $12,000 x 50/75 = $8,000 but limited to $3,000 (remaining income) because dual use property can’t create a loss Step 5: = What amount goes to Schedule A? ($ 4,500 taxes/interest – $3,000 rental = $1,500 ) Step 6: = What is the loss carry forward? $ 8,000 – 3,000 = $5,000
  9. 9. <ul><li>IRS requires that dual use of rental property allocation is based on total days of use </li></ul><ul><li>U.S. Tax Court has allowed allocation of interest and taxes using 365 as denominator </li></ul><ul><ul><li>This allows more interest/taxes to be deducted on Schedule A, creating greater potential to take other expenses on the Schedule E </li></ul></ul><ul><li>This controversy between IRS and Tax Court is still not resolved </li></ul>2010 Cengage Learning
  10. 10. <ul><li>Passive loss rule - When taxpayer has minimal or no involvement in an activity, generated losses are considered “passive” and may not be deducted in excess of passive gains, however: </li></ul><ul><ul><li>Loss can be carried forward and deducted in future years </li></ul></ul><ul><ul><li>or </li></ul></ul><ul><ul><li>Can be deducted when investment is sold </li></ul></ul><ul><li>Examples of passive activities </li></ul><ul><ul><li>Limited partnerships </li></ul></ul><ul><ul><li>Rental real estate </li></ul></ul>2010 Cengage Learning
  11. 11. Passive Losses Rules <ul><li>Require income and losses to be separated into three categories: </li></ul><ul><ul><li>Active </li></ul></ul><ul><ul><li>Portfolio </li></ul></ul><ul><ul><li>Passive </li></ul></ul><ul><li>Generally, disallow the deduction of passive losses against active or portfolio income </li></ul>
  12. 12. Passive Losses Rules <ul><li>In general, passive losses can only offset passive income </li></ul><ul><li>Passive losses are also subject to the at-risk rules </li></ul><ul><ul><li>Designed to prevent taxpayers from deducting losses in excess of their economic investment in an activity </li></ul></ul>
  13. 13. At Risk Limits <ul><li>At-risk defined </li></ul><ul><ul><li>The amount of a taxpayer’s economic investment in an activity </li></ul></ul><ul><ul><ul><li>Amount of cash and adjusted basis of property contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt) </li></ul></ul></ul>
  14. 14. At Risk Limits <ul><li>At-risk defined </li></ul><ul><ul><li>At-risk amount does not include nonrecourse debt unless the activity involves real estate </li></ul></ul><ul><ul><ul><li>For real estate activities, qualified nonrecourse debt is included in determining at-risk limitation </li></ul></ul></ul>
  15. 15. At Risk Limits <ul><li>At-risk limitation </li></ul><ul><ul><li>Can deduct losses from activity only to extent taxpayer is at-risk </li></ul></ul><ul><ul><li>Any losses disallowed due to at-risk limitation are carried forward until at-risk amount is increased </li></ul></ul><ul><ul><li>Previously allowed losses must be recaptured to the extent the at-risk amount is reduced below zero </li></ul></ul><ul><ul><li>At-risk limitations must be computed for each activity of the taxpayer separately </li></ul></ul>
  16. 16. At Risk Limits <ul><li>Interaction of at-risk rules with passive loss rules </li></ul><ul><ul><li>At-risk limitation is applied FIRST to each activity to determine maximum amount of loss allowed for year </li></ul></ul><ul><ul><li>THEN, passive loss limitation applied to ALL losses from ALL passive activities to determine actual amount of loss deductible for year </li></ul></ul>
  17. 17. Calculation of At-Risk Amount <ul><li>Increases to a taxpayer’s at-risk amount: </li></ul><ul><ul><li>Cash and the adjusted basis of property contributed to the activity </li></ul></ul><ul><ul><li>Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity </li></ul></ul><ul><ul><li>Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing </li></ul></ul><ul><ul><li>Taxpayer’s share of the activity’s income </li></ul></ul><ul><li>Decreases to a taxpayer’s at-risk amount: </li></ul><ul><ul><li>Withdrawals from the activity </li></ul></ul><ul><ul><li>Taxpayer’s share of the activity’s loss </li></ul></ul><ul><ul><li>Taxpayer’s share of any reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt </li></ul></ul>
  18. 18. Passive Loss Limits <ul><li>Active income </li></ul><ul><ul><li>Wages, salary, and other payments for services rendered </li></ul></ul><ul><ul><li>Profit from trade or business activity in which taxpayer materially participates </li></ul></ul><ul><ul><li>Gain from sale or disposition of assets used in an active trade or business </li></ul></ul><ul><ul><li>Income from intangible property created by taxpayer </li></ul></ul>
  19. 19. PASSIVE LOSS LIMITS <ul><li>Portfolio income </li></ul><ul><ul><li>Interest, dividends, annuities, and certain royalties not derived in the ordinary course of business </li></ul></ul><ul><ul><li>Gains/losses from disposition of assets that produce portfolio income or held for investment </li></ul></ul>
  20. 20. PASSIVE LOSS LIMITS <ul><li>Passive losses defined </li></ul><ul><ul><li>Losses from trade or business activities in which taxpayer does not materially participate, and </li></ul></ul><ul><ul><li>Certain rental activities </li></ul></ul>
  21. 21. Passive Loss Limits <ul><li>Limitations on passive losses </li></ul><ul><ul><li>Generally, passive losses can only offset passive income, i.e., they cannot reduce active or portfolio income </li></ul></ul><ul><ul><li>Disallowed losses are suspended and carried forward </li></ul></ul><ul><ul><ul><li>Suspended losses must be allocated to specific activities </li></ul></ul></ul>
  22. 22. Passive Loss Limits <ul><li>Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction </li></ul>
  23. 23. Passive Loss Limits <ul><li>Passive credits </li></ul><ul><ul><li>Credits from passive activities are subject to loss limitation </li></ul></ul><ul><ul><li>Utilize passive credits to the extent of tax attributable to passive income </li></ul></ul><ul><ul><li>Credits disallowed are suspended and carried forward similar to losses </li></ul></ul><ul><ul><ul><li>Suspended credits can be used to offset tax from disposition of activity but any credits left after activity is disposed of are lost forever </li></ul></ul></ul>
  24. 24. Passive Loss Limits <ul><li>Taxpayers subject to rules </li></ul><ul><ul><li>Individuals, estates, trusts, personal service corporations </li></ul></ul><ul><ul><li>Closely-held corporations </li></ul></ul><ul><ul><ul><li>Can deduct passive losses against active income </li></ul></ul></ul><ul><ul><li>S Corp and partnership passive losses flow through to owners and limits applied at the owner level </li></ul></ul>
  25. 25. Passive Loss Issues <ul><li>Passive losses are losses from trade or business activities in which taxpayer does not materially participate and certain rental activities </li></ul><ul><li>What constitutes an activity? </li></ul><ul><li>What is “material participation&quot;? </li></ul><ul><li>When is an activity a rental activity? </li></ul>
  26. 26. Identification of Activities <ul><li>Taxpayers with complex business operations must determine if segments of their business are separate activities or entire business is treated as a single activity </li></ul>
  27. 27. Identification of Activities <ul><li>Regs allow grouping multiple trade or businesses if they form an appropriate economic unit for measuring gain or loss </li></ul><ul><ul><li>Once activities are grouped, can’t regroup unless: </li></ul></ul><ul><ul><ul><li>Original groups were clearly inappropriate, or </li></ul></ul></ul><ul><ul><ul><li>Material change in circumstances </li></ul></ul></ul>
  28. 28. Identification of Activities <ul><li>Factors given greatest weight in determining an appropriate economic unit include: </li></ul><ul><ul><li>Similarities and differences in types of businesses </li></ul></ul><ul><ul><li>Extent of common control and ownership </li></ul></ul><ul><ul><li>Geographic location of different units </li></ul></ul><ul><ul><li>Interdependencies among the activities </li></ul></ul>
  29. 29. Material Participation Tests <ul><li>An activity is treated as active rather than passive (thus, not subject to the passive loss limits) if taxpayer meets one of 7 material participation tests </li></ul><ul><li>Participation is generally defined as work performed by an owner </li></ul>
  30. 30. Material Participation Tests <ul><li>Test 1 </li></ul><ul><ul><li>Taxpayer participates in the activity more than 500 hours during the year </li></ul></ul>
  31. 31. Material Participation Tests <ul><li>Test 2 </li></ul><ul><ul><li>Taxpayer’s participation in the activity is substantially all of the participation in the activity of all individuals for the year </li></ul></ul>
  32. 32. Material Participation Tests <ul><li>Test 3 </li></ul><ul><ul><li>Taxpayer participates in the activity more than 100 hours during the year and not less than the participation of any other individual in the activity </li></ul></ul>
  33. 33. Material Participation Tests <ul><li>Test 4 </li></ul><ul><ul><li>Taxpayer’s participation in the activity is significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours </li></ul></ul><ul><ul><li>Significant participation is more than 100 hours </li></ul></ul>
  34. 34. Material Participation Tests <ul><li>Test 5 </li></ul><ul><ul><li>Taxpayer materially participated in the activity for any 5 years during the last 10 year period </li></ul></ul>
  35. 35. Material Participation Tests <ul><li>Test 6 </li></ul><ul><ul><li>The activity is a personal service activity in which the taxpayer materially participated for any 3 preceding years </li></ul></ul>
  36. 36. Material Participation Tests <ul><li>Test 7 </li></ul><ul><ul><li>Based on the facts and circumstances, taxpayer participated in the activity on a regular, continuous, and substantial basis </li></ul></ul><ul><ul><ul><li>Regular, continuous, and substantial are not specifically defined in the Regulations </li></ul></ul></ul>
  37. 37. <ul><li>Rental property is specifically designated as passive, even if taxpayer actively manages </li></ul><ul><li>However, individual taxpayers </li></ul><ul><ul><li>May take up to $25,000 of rental loss (even though considered passive) against ordinary income </li></ul></ul><ul><ul><li>The $25,000 loss capability is reduced by 50¢ for each $1 modified AGI (MAGI) > $100,000 * </li></ul></ul><ul><ul><li>*Therefore, no deduction for rental losses exist for MAGI reaches $150,000 </li></ul></ul>2010 Cengage Learning
  38. 38. <ul><li>If taxpayer if heavily involved in real estate rental activities, may be considered to have an active business </li></ul><ul><li>Requirements are </li></ul><ul><ul><li>50% or more of individual’s personal service during year is performed in real property trade </li></ul></ul><ul><ul><li> and </li></ul></ul><ul><ul><li>More than 750 hours of service performed </li></ul></ul><ul><li>Then taxpayer may be able to deduct entire loss on real estate business </li></ul>2010 Cengage Learning
  39. 39. 2010 Cengage Learning Example Bobbi Jo is single and owns one rental duplex that showed a loss of $20,000. Her modified AGI before the loss is $118,000. What amount of the rental loss can be claimed?
  40. 40. 2010 Cengage Learning Example Bobbi Jo is single and owns one rental duplex that showed a loss of $20,000. Her modified AGI before the loss is $118,000. What amount of the rental loss can be claimed? Solution Step 1 Modified AGI exceeds $100,000 (therefore, $25,000 allowable loss may be reduced) Step 2 $118,000 - $100,000 = $18,000 excess, $25,000 - ($18,000 x 50%) = $16,000 Only $16,000 of the rental loss can be deducted
  41. 41. <ul><li>Bad debts arise when taxpayer sells good/services on credit and accounts receivable later becomes uncollectible </li></ul><ul><ul><li>Deduction for bad debts allowed up to amount previously included in income - cash basis taxpayers cannot take bad debts expense </li></ul></ul><ul><ul><li>As they never reported original income </li></ul></ul><ul><li>Must use specific charge-off method </li></ul><ul><ul><li>IRS requires proof of worthlessness </li></ul></ul>2010 Cengage Learning
  42. 42. <ul><li>Two types of bad debts </li></ul><ul><li>Business bad debts are ordinary deductions </li></ul><ul><ul><li>Those that arise from trade/business </li></ul></ul><ul><ul><li>These are deductible </li></ul></ul><ul><li>Non-business bad debts are short-term capital losses, which are netted against other capital gains and losses </li></ul><ul><ul><li>Report on Schedule D </li></ul></ul><ul><ul><li>Subject to $3,000/year loss limitation (discussed in Chapter 8 in more detail) </li></ul></ul>2010 Cengage Learning
  43. 43. <ul><li>Example </li></ul><ul><li>Keiko (a dentist) loans her friend, Lars, $20,000 to start an upholstery business. Subsequently, Lars cannot repay Keiko; is this a business or a non-business bad debt and how much may Keiko deduct in the current year? </li></ul>2010 Cengage Learning
  44. 44. <ul><li>Example </li></ul><ul><li>Keiko (a dentist) loans her friend, Lars, $20,000 to start an upholstery business. Subsequently, Lars cannot repay Keiko; is this a business or a non-business bad debt and how much may Keiko deduct in the current year? </li></ul><ul><li>Solution </li></ul><ul><li>This is a non-business bad debt as Keiko is not in the business of loaning money. It is a short-term capital loss (limited to $3,000 of deduction against ordinary income in any one year). She may carry forward the balance of the capital loss to future years. </li></ul>2010 Cengage Learning
  45. 45. <ul><li>Cost of goods sold (COGS) is a significant deduction for many retail businesses </li></ul><ul><ul><li>Cost of beginning and ending inventory crucial to calculation of deduction </li></ul></ul><ul><ul><li>LIFO and FIFO most commonly used methods of costing inventory </li></ul></ul><ul><li>If LIFO is used for tax, it must also be used for financial statement purposes </li></ul><ul><ul><li>Form 970 used to elect LIFO </li></ul></ul>2010 Cengage Learning
  46. 46. <ul><li>NOLs are losses resulting from business and casualty items only </li></ul><ul><li>First, carry it back two years and then forward twenty </li></ul><ul><ul><li>File amendments for prior years (1040X) or </li></ul></ul><ul><ul><li>1045 (for quick claim for refund) </li></ul></ul><ul><ul><li>or </li></ul></ul><ul><li>May make an irrevocable election to forego carry back, then carry forward </li></ul><ul><ul><li>But must elect this in year of loss </li></ul></ul><ul><ul><li>American Recovery & Reinvestment Act provides relief for businesses that incurred an NOL in 2008. It allows them to elect to carry back the NOL to the most beneficial year between 2003 and 2006 (or carry it forward and forego carry back). </li></ul></ul>2010 Cengage Learning
  47. 47. <ul><li>Traditional IRA </li></ul><ul><ul><li>Deduction for AGI if certain conditions met </li></ul></ul><ul><ul><li>Distributions in retirement are taxable </li></ul></ul><ul><li>Roth IRA </li></ul><ul><ul><li>No current deduction </li></ul></ul><ul><ul><li>Distributions in retirement are nontaxable </li></ul></ul>2010 Cengage Learning
  48. 48. <ul><li>Roth or traditional IRA contribution limited to lesser of: </li></ul><ul><ul><li>100% of earned income </li></ul></ul><ul><ul><ul><ul><li>or </li></ul></ul></ul></ul><ul><ul><li>$5,000 </li></ul></ul><ul><ul><ul><li>Spouse with no earned income will be able to contribute up to $5,000 </li></ul></ul></ul><ul><ul><ul><li>For 2009, taxpayers and spouses age 50 and over can contribute an additional $1,000/year (called “catch-up provision”) </li></ul></ul></ul>2010 Cengage Learning Can make contributions up through April 15, 2010 for 2009
  49. 49. <ul><li>Roth IRA contribution maximum is reduced for all taxpayers over certain income levels </li></ul><ul><ul><li>Phase-out for contribution is reflected in table on page 3-15 </li></ul></ul><ul><li>If taxpayer contributes to both a traditional and Roth IRA, combined amount cannot exceed $5,000 ($6,000 if 50 or over) </li></ul>2010 Cengage Learning
  50. 50. <ul><li>Traditional IRA deduction is dependent on AGI and active participation in another qualified retirement plan </li></ul><ul><ul><li>Single taxpayers – see table on top of page 3-16 </li></ul></ul><ul><ul><li>MFJ taxpayers – see table, phase-outs based on if one, both or neither spouse is an active participant </li></ul></ul><ul><ul><ul><li>Note: if only one spouse is in a qualified plan, phase out for the non-active participant spouse begins when married filing joint couple’s AGI > $166,000 </li></ul></ul></ul>2010 Cengage Learning
  51. 51. <ul><li>Example </li></ul><ul><li>Owen is 42, single, and wants to contribute the maximum to his Roth IRA. His AGI = $105,000, so his contribution will be limited. Please calculate how much of IRA contribution is allowed. How would that change if Owen were 62? </li></ul>2010 Cengage Learning
  52. 52. <ul><li>Example </li></ul><ul><li>Owen is 42, single, and wants to contribute the maximum to his Roth IRA. His AGI = $110,000, so his contribution will be limited. How much of IRA contribution is allowed? How would that change if Owen were 62? </li></ul><ul><li>Solution </li></ul><ul><li>Look at the phase-out chart on p. 3-15. The denominator to the calculation is the range of the phase-out amounts. </li></ul><ul><li>($120,000 – $110,000)/$15,000 x $5,000 = $3,333 Roth IRA contribution </li></ul><ul><li>If he were 62: </li></ul><ul><li>($120,000 – $110,000)/$15,000 x $6,000 = $4,000 Roth IRA contribution </li></ul>2010 Cengage Learning $120,000 - $105,000
  53. 53. <ul><li>Example </li></ul><ul><li>Liza and Mikal (both 41) filed married filing jointly. Liza is covered by a 401(k) plan at work and earns $96,000. Mikal is not covered by a plan at work and earns $30,000. How much can each of them contribute to a traditional IRA? </li></ul>2010 Cengage Learning
  54. 54. <ul><li>Example </li></ul><ul><li>Liza and Mikal (both 41) are MFJ; Liza is covered by a 401(k) plan at work and earns $96,000. Mikal is not covered by a plan at work and earns $30,000. How much can each of them contribute to a traditional IRA? </li></ul><ul><li>Solution </li></ul><ul><li>Their combined AGI = $126,000. Their AGI exceeds the top end of the phase-out range for MFJ for ‘active participant spouse’, per Note 1 on the table on page 3-16. </li></ul><ul><li>Since Liza is the active plan participant, she may not make a deductible contribution to a traditional IRA. She could, however, make a $5,000 contribution to a Roth IRA, since their AGI is not in the Roth phase-out range (see table page 3-15). </li></ul><ul><li>Mikal can make the full $5,000 traditional IRA contribution since the AGI phase-out for the spouse that is not in an active plan does not kick in until $166,000. </li></ul>2010 Cengage Learning
  55. 55. <ul><li>Distribution taxed as ordinary income </li></ul><ul><ul><li>Must begin taking distributions by age 70.5 </li></ul></ul><ul><ul><li>There’s a 10% penalty if you take distribution before age 59.5 plus tax </li></ul></ul><ul><ul><li>Penalty-free withdrawals from IRAs may be made by taxpayers who are: </li></ul></ul><ul><ul><ul><li>Disabled </li></ul></ul></ul><ul><ul><ul><li>Using special level payment option </li></ul></ul></ul><ul><ul><ul><li>Purchasing a home for the first time (up to $10,000) </li></ul></ul></ul><ul><ul><ul><li>Paying higher education expenses </li></ul></ul></ul><ul><ul><ul><li>Paying medical expenses > 7.5% of AGI or medical insurance premiums for dependents and on unemployment at least 12 weeks </li></ul></ul></ul><ul><ul><ul><li>Note: in order to offer relief to retirees after stock market drop, minimum distribution requirements suspended for 2009 only </li></ul></ul></ul>2010 Cengage Learning
  56. 56. <ul><li>Qualified distributions are tax free as long as Roth IRA was open for five years </li></ul><ul><li>and </li></ul><ul><ul><li>Distribution is made on/after age 59.5 </li></ul></ul><ul><ul><li>Distribution is made due to a disability </li></ul></ul><ul><ul><li>Distribution is made on/after participant’s death </li></ul></ul><ul><ul><li>Distribution is used for first time home-buyer’s expenses </li></ul></ul>2010 Cengage Learning
  57. 57. <ul><li>Participants must meet minimum age and years of service requirements </li></ul><ul><li>Retirement plan geared towards self-employed individuals </li></ul><ul><li>Tax free contributions are limited to lesser of 20% of net earned income (before Keogh deduction) or $49,000 </li></ul><ul><ul><li>Net earned income includes business profits if significantly generated from taxpayer’s personal services </li></ul></ul><ul><ul><li>Must reduce net earned income by ½ self-employment tax for contribution calculation </li></ul></ul>2010 Cengage Learning
  58. 58. <ul><li>Same dollar limits as Keogh plans, but contributions made to SEP-IRA </li></ul><ul><ul><li>IRA account with higher funding limits </li></ul></ul><ul><li>Participants must meet minimum age and years of service requirements </li></ul><ul><li>Pay early withdrawal penalty if receive distributions prior to age 59.5 </li></ul><ul><li>Must start drawing by age 70.5 </li></ul>2010 Cengage Learning
  59. 59. <ul><li>Contributions by an employer to qualified retirement plans are tax deductible </li></ul><ul><ul><li>Employee contributions are pre-tax </li></ul></ul><ul><ul><li>Tax on earnings is deferred </li></ul></ul><ul><li>To achieve qualified plan status, an employer-sponsored retirement plan must </li></ul><ul><ul><li>Be for exclusive benefit of employees </li></ul></ul><ul><ul><li>Be nondiscriminatory </li></ul></ul><ul><ul><li>Have certain participation and coverage requirements </li></ul></ul><ul><ul><li>Comply with minimum vesting requirements </li></ul></ul><ul><ul><li>Meet uniform distribution rules </li></ul></ul><ul><li>Limitations on contributions to/benefits from qualified plans </li></ul><ul><ul><li>Defined contribution – annual addition to employee’s account can’t exceed lesser of 25% of compensation or $49,000 </li></ul></ul><ul><ul><li>Defined benefit – annual benefit can’t exceed lesser of $195,000 or average compensation for the highest three consecutive years </li></ul></ul>2010 Cengage Learning
  60. 60. <ul><li>§401(k) </li></ul><ul><ul><li>Employee chooses to defer some compensation into plan </li></ul></ul><ul><ul><ul><li>Defer means to forego current compensation - the reduction goes into a qualified retirement plan </li></ul></ul></ul><ul><ul><ul><li>Employees choose % of wages to contribute to plan </li></ul></ul></ul><ul><ul><ul><li>Not to exceed $16,500/year for all salary reduction plans </li></ul></ul></ul><ul><ul><ul><ul><li>$22,000/year if 50 or older </li></ul></ul></ul></ul><ul><ul><li>An employer may match to encourage participation, this is excludable from income </li></ul></ul><ul><ul><li>When distributions occur, contributions/earnings taxable </li></ul></ul>2010 Cengage Learning
  61. 61. <ul><li>Beginning in 2006, employers allowed to set up Roth §401(k) plan </li></ul><ul><ul><li>Employees may defer same annual amount as traditional 401(k), but with no reduction in current taxable income </li></ul></ul><ul><ul><li>Withdrawals/earnings generally tax free upon distribution </li></ul></ul><ul><li>Expected to be popular with high income taxpayers because no AGI phase-out and much higher annual contribution than a Roth IRA </li></ul>2010 Cengage Learning
  62. 62. <ul><li>Credit to encourage low-income taxpayer participation in retirement savings </li></ul><ul><li>Tax credit for percentage of retirement plan contribution based upon AGI </li></ul><ul><ul><li>Credit equal to 50%, 20% or 10% of contribution </li></ul></ul><ul><ul><li>See chart on page 3-22 </li></ul></ul><ul><ul><li>Credit is direct deduction from income taxes payable </li></ul></ul>2010 Cengage Learning
  63. 63. <ul><li>Taxpayer instructs trustee of plan to directly transfer assets to trustee of another plan </li></ul><ul><li>No backup tax withholding necessary because $ goes right from one plan to another </li></ul><ul><li>Unlimited number of direct transfers per year </li></ul>Plan 1 Plan 2 2010 Cengage Learning Taxpayer
  64. 64. <ul><li>Taxpayer receives assets from fund, and then has 60 days to get 100% of the $ from one plan to another to avoid penalties </li></ul><ul><ul><li>Or 120 days if first-time homebuyer, waived in other situations </li></ul></ul><ul><li>20% federal backup tax withholding is mandatory </li></ul><ul><ul><li>So taxpayer must make up the 20% withholding and then wait until year-end to get refund!! Also if under 59.5 years old, portion of plan distribution not transferred subject to 10% penalty </li></ul></ul><ul><ul><li>IRA distributions not subject to mandatory withholding </li></ul></ul>Plan 1 Taxpayer Plan 2 2010 Cengage Learning 80% of $
  65. 65. <ul><li>Example </li></ul><ul><li>Theo is 54 and instructs her employer, Ecotrek LLP, to distribute $250,000 of her non-IRA retirement account to her. How much must the trustee of the fund withhold and what must Theo do to avoid taxes and penalties on the distribution in the current year? </li></ul>2010 Cengage Learning
  66. 66. <ul><li>Example </li></ul><ul><li>Theo is 54 and instructs her employer, Ecotrek LLP, to distribute $250,000 of her non IRA retirement accountto her. How much must the trustee of the fund withhold and what must Theo do to avoid taxes and penalties on the distribution in the current year? </li></ul><ul><li>Solution </li></ul><ul><li>The trustee must withhold 20%; therefore, Theo will receive $200,000 ($250,000 less withholding of $50,000). To avoid taxes she must contribute $250,000 to a new fund within 60 days. If Theo does not have the extra $50,000 to contribute, that portion of the distribution will be included in her taxable income and she will be subject to a 10% penalty. If she can contribute the full $250,000; the amount withheld will be accounted for on her annual tax return. </li></ul>2010 Cengage Learning
  67. 67. <ul><li>Designed for use by employers with less than 100 employees </li></ul><ul><li>SIMPLE-IRA </li></ul><ul><ul><li>Employees can defer up to $11,500 per year into SIMPLE-IRA or $14,000 if 50 or older </li></ul></ul><ul><li>Employer must either: </li></ul><ul><ul><li>Match employees’ contributions dollar for dollar up to 3% of gross wages </li></ul></ul><ul><ul><li>or </li></ul></ul><ul><ul><li>Contribute 2% of gross wages of all employees who make over $5,000 per year (even if they don’t elect salary deferral) </li></ul></ul><ul><li>Contributions are fully vested when made; first 2 years early withdrawals are subject to 25% penalty </li></ul>2010 Cengage Learning
  68. 68. <ul><li>Example </li></ul><ul><li>Sue, age 39, earns $70,000 and chooses 8% salary deferral to a SIMPLE IRA. How much is her contribution and what is the employer matching (assuming the 3% provision)? </li></ul>2010 Cengage Learning
  69. 69. <ul><li>Example </li></ul><ul><li>Sue, age 39, earns $70,000 and chooses 8% salary deferral to a SIMPLE IRA. How much is her contribution and what is the employer matching (assuming the 3% provision)? </li></ul><ul><li>Solution </li></ul><ul><li>Sue contributes $5,600 to the plan and her employer matches $2,100 (dollar for dollar up to 3% maximum match ($70,000 x 3%)). </li></ul>2010 Cengage Learning
  70. 70. <ul><li>Example </li></ul><ul><li>John, age 43, works for a computer software design business and has a salary of $500,000; John chooses 10% salary deferral (not to exceed maximum allowable by law). How much is his contribution and what is the employer matching (assuming the 2% provision)? </li></ul>2010 Cengage Learning
  71. 71. <ul><li>Example </li></ul><ul><li>John, age 43, works for a computer software design business and has a salary of $500,000; John chooses 10% salary deferral (not to exceed maximum allowable by law). How much is his contribution and what is the employer matching (assuming the 2% provision]) </li></ul><ul><li>Solution </li></ul><ul><li>John contributes $13,000 to the plan [since $500,000 x 10% exceeds the maximum, he is only allowed $11,500]. His employer matches $10,000 (dollar for dollar up to 2% maximum match ($500,000 x 2%)). </li></ul>2010 Cengage Learning
  72. 72. 2010 Cengage Learning

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