EXPLANATIONS TO STUDY QUESTIONS
1. (d) A deductible contribution of $2,000 will reduce taxable income by $2,000. In the 28% tax bracket, there will be an immediate tax savings of $560 (28% x $2,000).
2. (b) Earnings in an IRA are tax deferred. The IRS taxes the earnings when they are withdrawn from the account. There is no tax consequence to transfers between IRA custodians. There is no tax liability when a distribution is rolled over between custodians provided the rollover is accomplished within 60 calendar days -- the IRS will impose withholding against the rollover, but this can be refunded upon proper completion of the rollover.
3. (c) IRAs may be established for a given year at any time between January 1st of that year and the tax filing deadline of April 15th of the following year.
4. (c) Dividends, interest and capital gains are referred to as "investment" or "portfolio" income. They are not sources of "earned" income.
5. (c) Current regulations allow workers to contribute the lesser of 100% of earned income or $2,000 per year. In this case 100% of earned income is less, so she may contribute $1,500.
6. (a) Workers may contribute to a traditional IRA up to age 70½ Dr. Knight may not contribute to an IRA, even though he has earned income, because he is too old.
7. (c) Although traditional IRAs limit workers older than age 70½ from contributing to their IRA, a Roth IRA permits contributions at any age. Dr. Knight may contribute up to $2,000 to a Roth IRA.
8. (b) Excess contributions to an IRA are subject to a 6% penalty. In this case, Mr. Brady is entitled to contribute $2,000. The 6% penalty is applied to the excess $1,000 contribution. He must pay a penalty of $60. Current rules require the excess contribution of $1,000 to be withdrawn from the account promptly.
9. (b) In this example, both spouses have earned income, so both may contribute $2,000 to their IRAs, on their own behalf (i.e., not as spousal IRAs). John is an active participant in a qualified plan while Mary is not. As an "active participant" in a pension plan and earning more than $60,000 jointly (the income threshold in 1998), John's contribution is not tax deductible. Mary, on the other hand, is not an "active participant", her contribution may be tax-deductible. Deductions for such contributions phase out when joint income is between $150,000 and $160,000. Her contribution is tax deductible since the couple earned less than $150,000.
10. (a) In this example, both spouses have earned income, so both may contribute $2,000 to their IRAs, on their own behalf (i.e., not as spousal IRAs). John is an active participant in a qualified plan while Mary is not. As an "active participant" in a pension plan and earning more than $60,000 jointly (the income threshold in 1998), John's contribution is not tax deductible. Mary, on the other hand, is not an "active participant", her contribution may be tax-deductible. Deductions for such contributions phase out when joint income reaches $160,000. Her contribution is not tax deductible since the couple earned more than $160,000 -- the income cutoff for such deductions.
11. (a) Whether the employee's pension benefits are vested or not is immaterial. This employee is "eligible" for a pension plan -- so he is an "active participant". Since he earns more than $40,000 per year any contributions are non-deductible. He may make a contribution of $2,000 to a non-deductible IRA.
12. (b) For individual taxpayers covered by a qualified pension plan, the deductibility of IRA contributions is "phased out" at the rate of $1 for every $5 of earnings above $30,000. Jim earned $7,000 more than the $30,000 limit. The non-deductible portion of his contribution is $1,400 ($7,000 divided by 5). The remaining $600 of the contribution is deductible.
13. (c) Individuals are limited in the number of rollovers they may make in any 12 month period. There are no such limitations on the number of transfers they may make.
14. (d) This is an example of a rollover -- and is a prime example of why the IRS limits the number of rollovers an IRA holder is entitled to. Because the IRA funds were redeposited in an IRA within 60 days of the withdrawal, there is no tax consequence. If they had not been redeposited, Mr. Hunt would have to pay taxes on the withdrawal, plus a penalty for early withdrawal. [By the way, this type of activity should not be recommended to clients.]
15. (c) Movement of IRA or pension plan assets directly between custodians is an example of a transfer, not a rollover.
16. (b) Rolling lump sum distributions into an IRA is a way of delaying the tax bite on the pension distribution. Taxes will be owed when money is withdrawn, which must begin no later than age 70½. Rollovers do not "eliminate" taxes. By placing the pension plan assets in the IRA, they will not generate current income for the IRA holder. There is no law which requires rollovers of pension plan assets.
17. (c) To avoid taxes on the pension plan distribution, Mr. Franklin should roll the distribution into an IRA. Since he is seeking another job with retirement benefits, he may wish to eventually move the "old pension" money to the new employer's plan. If the lump sum is commingled with other IRA assets (such as the account established with deductible contributions), the pension money can not be subsequently moved into the new pension plan. The best course of action is to hold that money in a separate IRA account -- a Conduit IRA.
18. (d) IRS rules prohibit the investment of IRA assets in life insurance policies.
19. (c) Collectibles and precious metals are prohibited investments in an IRA with the exception of US Gold Eagle coins and certain types of bullion.
20. (c) Mutual funds provide the most convenient investment in an self-directed IRA. Almost 40% of IRA investors own at least one stock fund, 12% are invested in bond funds, and 27% hold money market funds in their IRAs. Certificates of deposit are typically held in bank IRAs.
21. (d) All of the choices presented are suitable for conservative investors. However, municipal bond funds would be poor choice as an IRA investment. In an IRA, the earnings are tax deferred. The lower, tax free yields of municipal bonds is a disadvantage for an IRA investor. Tax advantaged investments, such as municipal bonds are best held in the individual's "regular" accounts -- not an IRA.
22. (d) Fixed income securities, such as bonds (both interest paying and zero coupon), are subject to inflation risk. Stocks, with their potential for appreciation, provide a better inflation hedge than bonds. Growth stocks have greater appreciation potential than utility stocks.
23. (d) Once an IRA has been established, the holder may withdraw funds at any time. However, premature withdrawals subject the IRA owner to a 10% penalty.
24. (c) Withdrawals prior to age 59½ are subject to a 10% penalty in addition to the taxes owed on the amount withdrawn. The penalty can be avoided in the event of death or disability.
25. (d) Taxes on any earnings in the account, whether from dividends, interest or capital gains, are deferred until withdrawal from the account. There is no requirement that withdrawal begin at age 59½ , or at retirement.
26. (c) Withdrawals prior to age 59½ are subject to a 10% penalty in addition to the taxes owed on the amount withdrawn. The penalty can be avoided in the event of death or disability. There is no exemption for "financial hardship". Mr., Johnson owes taxes of $1,400 (28% of $5,000) plus a penalty of $500 (10% of $5,000).
27. (d) Withdrawals prior to age 59½ are subject to a 10% penalty in addition to the taxes owed on the amount withdrawn. The penalty can be avoided in the event of death or disability. The penalty may also be avoided if the distributions are taken in "substantially equal periodic payments". There is no exception for "financial hardship".
28. (c) Mandatory withdrawals are required once an IRA holder reaches age 70½ . Failure to take the required amount results in a 50% penalty. The amount of the required annual distribution is found by dividing the value of the account (as of January 1st of the year) by the life expectancy of the holder (based on age as of December 31st). In this case the woman must withdraw $3,950 ($39,500 divided by 10.0 years) to avoid the 50% penalty. She will, of course, pay taxes on any amounts withdrawn.
29. (d) The IRS requires the first mandatory withdrawal from an IRA to be taken no later than April 1st of the year following the year in which the account holder reaches age 70½ . In this case, Mrs. Thompson reaches age 70½ in 1999 (her 70th birthday was August 1, 1998). She must begin withdrawals no later than April 1st of the following year - 2000.
30. (b) The man is required to withdraw $5,000 from the account ($66,000 value divided by 13.2 year life expectancy). Since he withdrew only $3,000, he is subject to the 50% penalty on the $2,000 undistributed amount - the "excess accumulation". His penalty is $1,000 (50% of $2,000).
31. (c) Since the tax advantages of a Roth IRA occur upon withdrawal, these accounts have been called "backloaded" IRAs.
32. (c) Contributions to a Roth IRA are never tax-deductible.
33. (d) While persons over age 70½ may not establish or contribute to a traditional IRA, these rules do not apply to Roth IRAs. Persons of any age, with earned income, may establish and contribute to a Roth IRA. Persons of all ages may roll assets over from an existing plan in both traditional and Roth IRAs.
34. (d) Persons of any age may contribute to a Roth IRA, provided they "earn" income during the year, and their income does not exceed $110,000 individually or $160,000 jointly.
35. (d) Mr. Able and Mr.Charlie could both contribute to either a traditional or Roth IRA. Mr. Charles contributions to a traditional IRA could be deducted on his tax return, while Mr. Able's is not deductible. Ms. Delta and Ms. Bravo are too old to contribute to a traditional IRA. Ms. Bravo could contribute to a Roth IRA, Ms. Delta could not as she earned more than $110,000 -- the income cutoff for single taxpayer Roth IRAs.
36. (d) The maximum contribution to a Roth IRA is identical to traditional IRA, 100% of earned income to a maximum of $2,000 per year.
37. (b) The IRS levies a 6% penalty for contributions made in excess of the permissible levels (100% of income up to $2,000) and for contributions made to a Roth IRA by those whose income exceed the permissible levels ($110,000 for single taxpayers and $160,000 for joint taxpayers).
38. (b) Excess contributions, in either Roth IRAs or traditional IRAs, may be withdrawn without penalty at any time prior to the taxpayer's filing date - April 15th for most taxpayers.
39. (a) The penalty on excess contributions in a Roth IRA is cumulative -- it applies for each year the excess remains in the account. Underfunding future contributions is one way to correct the situation, as is simply withdrawing the excess.
40. (d) All of these are "qualified distributions", allowing for tax-free distribution from a Roth IRA.
41. (d) To qualify for tax-free distributions the contributions must first remain in the Roth IRA for five "tax years".
42. (a) If the contributions did not remain in the Roth IRA for five "tax years" or are taken before age 59½, the distribution is nonqualified". These distributions are considered tax-free return of contributions then taxable earnings.
43. (a) There is no penalty on "premature" distributions from a Roth IRA. - just possible taxation as ordinary income
44. (a) There are no required mandatory distributions from a Roth IRA, and therefore no 50% penalty.
45. (d) To convert a traditional IRA into a Roth, the value of the account being converted is taxed as ordinary income - but there is no premature distribution penalty on such conversions.
46. (d) Any employer may establish a SEP. Employees may not establish a SEP.
47. (c) A Model SEP is the least expensive method to establish a retirement plan. The employer simply fills out a short IRS form and retains a copy for its files.
48. (d) The employer must cover all employees who are 21 or older, earn at least $300 per year and have worked for the employer for any three of the past five years. The employer may make the eligibility requirements less stringent.
49. (c) The only type of tax-advantaged retirement plan that may be set up and funded after the close of the tax year is a SEP.
50. (d) The contribution limit for SEPs is 15% of employee compensation up to a maximum of $30,000 per year.
51. (b) The employer claims a tax deduction for amounts contributed to an employee's SEP-IRA. The employee does not include that amount as taxable income (and therefore does not claim a deduction).
52. (c) Employees do not include any contributions made by an employer to their SEP-IRA as taxable income. That amount is "excluded" from income.
53. (c) Model SEPs are established when an employer signs Form 5305-SEP. This form is "pre-approved" and is not filed the IRS.
54. (d) Model SEPs require an IRA for each participating employee. These plans may not be integrated with Social Security, nor may they be established if the employer has maintained other qualified plans.
55. (d) Key personnel are any employees who serve as officers, or are also owners of the employer having a 5+% ownership interest; own 1+% of the employer and earn more than $150,000; or own one of the ten largest shares of the employer. Choice III is not an owner, and therefore is not a "key" employee.
56. (c) When qualified plans are top-heavy, they typically require an accelerated vesting schedule, Since contributions to a SEP-IRA are 100% immediately vested, they can't be accelerated. In top- heavy SEP plans, the employer must make a contribution of at least 3% for all non-key employees.
57. (b) Excess employer contributions are subject to a 10% penalty -- payable by the employer.
58. (d) Flat contributions formulas, such as a fixed dollar amount or fixed percentage of compensation are allowed, as are formulas in which the contribution level decreases as income increases. Formulas which have lower contribution levels for lower levels of compensation are discriminatory and therefore prohibited.
59. (c) For a SEP to work properly, each eligible employee must have an IRA to which the employer may contribute. If one doesn't exists, the employer may establish an IRA on the employee's behalf.
60. (c) Self-employed compensation is measured after all relevant business deductions have been made i.e., net income. The tax code requires the self-employed to deduct their contributions to the SEP and one-half of the self-employment tax as part of that calculation.
61. (a) Excess contribution that are withdrawn from the account are included in the employee's taxable income for that year, but there are no penalties. If withdrawn after the employee's tax filing date (usually April 15th) the excess contributions are subject to a 6% penalty for each year they remain in the account.
62. (a) Contributions to a SEP-IRA are usually made for employees who have reached age 21. Since funds may be withdrawn immediately (there is no deferred vesting allowed in a SEP), withdrawals can begin as soon as they are deposited in the account.
63. (d) As with traditional IRAs, distributions must begin when the account holder reaches age 70½.
64. (d) Employers may delay contributions to a SEP until the tax filing deadline for the tax year, plus any extensions.
65. (a) Employers must notify employees of their right to make SIMPLE plan deferrals, and the amount of the employer's contribution, before the election period. The election period must extend over at least 60 days.
66. (b) Employers base matching contributions to SIMPLE IRA plans on the employee's compensation. The inflation adjusted limit applies to compensation when calculating an employer's non-elective 2% contribution.
67. (c) Employers must either match employee contributions up to 3% of compensation, to contribute 2% as a non-elective contribution. Under certain circumstances, employers may choose to match SIMPLE IRA deferrals up to 1%, instead of 3%.
68. (b) Employees may contribute up to $2,000 to a "regular" IRA, while employee deferrals to SIMPLE IRAs is $6,000 (adjusted for inflation).
69. (c) SIMPLE plans may be established as 401(k) plans or IRAs.
70. (b) SIMPLE plans allow employers to ignore the non-discrimination and top heavy rules that apply to other 401(k) plans. SIMPLE plans must be in writing, require employer contributions and provide for 100% immediate vesting (which is more strict than allowed under ERISA).
71. (a) Only employers with no other qualified plan who employ fewer than 100 employees may establish a SIMPLE plan.
72. (d) When counting employees for purposes of the "100 employee rule", all employees must be counted -- even those not eligible to participate. If the employer controls more than one business all employees of all businesses must be counted.
73. (d) All SIMPLE plans operate on a calendar year basis.
74. (d) Employers may exclude certain employees from participating in the plan (i.e., contributing to the plan). Employers may exclude employees who have not earned $5,000 in any of the prior two years - these need not be consecutive years.
75. (d) Employees may participate in more than one SIMPLE plan each year - but may contribute no more than $6,000 to all such plans during the year.
76. (c) Employees need not defer compensation under a SIMPLE plan. However, the SIMPLE rules require employers to either match employee contributions or make non-elective contributions.
77. (b) Voluntary, after tax contributions are not permitted under the SIMPLE rules.
78. (d) Employees may terminate participation in the plan at any time.
79. (a) The rules require segregation of employee deferrals "as quickly as possible" - but under no circumstance later than the 15th of the following month.
80. (d) Employer contributions must be deposited into the plan by the employer's tax filing date, including extensions.
81. (d) All contributions to a SIMPLE plan are 100%, immediately vested.
82. (d) All contributions to a SIMPLE plan are 100%, immediately vested. Since voluntary contributions are not permitted in a SIMPLE plan, they cannot vest.