Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
Подождите немного. Документ загружается.
EXAMPLE Ann, who is 36 and single, would like to contribute $5,000 to her
Roth IRA. However, her AGI is $114,000, so her contribution is limited
to $2,000, calculated as follows:
($120,000 $114,000)
$15,000
$5,000 ¼ $2,000 allowed Roth IRA
The $15,000 denominator in the calculation above is the amount of
the phase-out range between $105,000 and $120,000. If she were 56
and wanted to contribute $6,000, her contribution would be limited
to $2,400. N
EXAMPLE Paul and Lucy are married and are both 36 years old. Lucy is covered
by a retirement plan and earns $59,000. Paul is not covered by a
retirement plan and earns $51,000. Lucy cannot make a deductible
contribution to a traditional IRA since the income on their joint tax
return is greater than the $109,000 maximum phase-out range for
married couples. Paul, however, can make a fully deductible IRA
contribution of $5,000 since he qualifies for the $167,000–$177,000
phase-out range when one spouse is an active participant in a plan
and the other is not. Lucy could still choose to make a $5,000 contri-
bution to a Roth IRA since their joint income is below the Roth IRA
phase-out range for married couples. Paul would have a choice
between mak ing a $5,000 deductible contribution to a traditional
IRA or a contribution of $5,000 to a Roth IRA or some combination
thereof not greater than $5,000. N
An IRA contribution may be made at any time before the origin al due date of the tax
return for the year in which the deduction is to be claimed. This means, for example,
that an individual can contribute to an IRA as late as April 15, 2011, and still deduct the
amount on the 2010 tax return.
Roth IRA Conversions
Taxpayers may benefit from a rule allowing conversions of regular IRAs into Roth IRAs.
Although the income generated by the conversion is subject to a current income tax, tax-
payers with certain factors in their favor such as many years to retirement, a low current tax
bracket, or a high expected tax bracket in retirement may wish to convert. Also, taxpayers
with negative taxable income due to large personal deductions may wish to convert enough
of their regular IRAs to Roth IRAs to bring taxable income to zero. This way the conver-
sion can be done with no tax cost since deductions which would otherwise be lost are used
to offset the taxable IRA income.
For tax years 2010 and beyond, a rule that required taxpayers to have $100,000 or less in
AGI to convert regular IRA accounts to Roth IRA accounts has been eliminated. Congress
expects that many high-income taxpayers will take advantage of this opportunity and pay
income tax due up front on the conversion. Taxpayers converting in 2010 can elect to
defer their tax to 2011 and 2012, but if a higher tax rate returns in 2011 or 2012, this elec-
tion may not pay off.
Section 3.6
Individual Retirement Accounts 3-19
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Traditional IRA Distributions
Money removed from a traditional IRA is taxable as ordinary income and may be subject to
a 10 percent penalty for early withdrawal. To avoid the 10 percent penalty, distributions
from an IRA generally cannot begin before age 59
1
/
2. Penalty-free withdrawals from
IRAs may be made by taxpayers who are:
1. Disabled
2. Using a special level payment option
3. Using the withdrawals for medical expenses in excess of 7.5 percent of their AGI
4. The recipients of at least 12 weeks of unemployment compensation and to the extent
they are paying medical insurance premiums for their dependents
5. Paying the costs of higher education, including tuition, fees, books, and room and
board for the taxpayers or their spouses, children, or grandchildren
6. Withdrawing up to $10,000 for first-time home-buying expenses
While withdrawals made by these taxpayers are penalty free, they are still subject to
income taxes. Also, taxpayers mus t start taking minimum annual distributions from their
IRA at age 70
1
/
2. The IRS provides tables for calculating the required minimum annual dis-
tributions based on the taxpayer’s life expectancy. For 2009 only, the required minimum
distribution was suspended to allow retirees some relief after the sharp drop in stock prices
in 2008.
EXAMPLE Tomas is 48 years old and has a mid-life crisis and decides he has to
have a red sports car. He withdraws $35,000 from his traditional IRA
to pay for it. Tomas does not qualify for any of the penalty-free with-
drawals listed earlier. The $35,000 is taxable to Tomas as ordinary
income and he is subject to a $3,500 (10% $35,000) penalty for
removing the funds before age 59
1
/
2. N
Roth IRA Distributions
A taxpayer can make tax-free withdrawals from a Roth IRA after a 5-year holding period if
any of the following requirements are satisfied:
1. The distrib ution is made on or after the date on which the participant attains
age 59
1
/
2.
2. The distribution is made to a beneficiary (or the participant’s estate) on or after the
participant’s death.
3. The participant becomes disabled.
4. The distribution is used to pay for qualified first-time home-buyer’s expenses.
EXAMPLE Bob establishes a Roth IRA at age 50 and contributes the maximum
each year for 10 years. The account is now worth $61,000, consisting
of $35,000 of nondeductible contributions and $26,000 in earnings
that have not been taxed. Bob may withdraw the $61,000 tax free
from the Roth IRA because he is over 59
1
/
2 and has met the 5-year
holding period requirem ent. N
The distributions may be taxable if the taxpayer receives distributions from a Roth IRA
and does not satisfy the above requirements. The part of the distributions that represents a
return of capital is tax free, and the part that represents a pay-out of earnings is taxable.
3-20 Chapter 3
Business Income and Expenses, Part I
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Under the ordering rules for Roth IRA distributions, distributions are treated as first made
from contributions (return of capital) and then from earnings.
EXAMPLE Assume the same facts in the above example, except that Bob is only
age 56 and receives distributions of $10,000. Assume his adjusted basis
for the Roth IRA is $12,000 (contributions made of $2,000 6 years).
The distribution is tax free and his adjusted basis is reduced to $2,000
($12,000 $10,000). N
A gift to a Roth IRA for a child or grandchild with a summer job can grow into a
very large gift over time. The amount that may be contributed to a child’s Roth
IRA is the lesser of $5,000 or the child’s earnings. A child wi th $5,000 in a Roth
IRA at age 16 will have well over $100,000 at age 65 if the Roth IRA investment
earns 7 percent.
SECTION 3.7
KEOGH (H.R. 10) PLANS AND SIMPLIFIED
EMPLOYEE PENSIONS
Keogh plans are the unincorporated business’s equivalent of the qualified retirement plans
discussed in Section 3.8. The array of retirement plans available for self-employed tax-
payers is now very similar to the retirement plans availa ble to corporate taxpayers, and
includes 401(k) plans, defined contribution plans, and defined benefit plans. The retire-
ment plan area has become one of the most complex areas of the tax law. Many tax account-
ants refer taxpayers to a specialist for help in choosing a plan and for guidance through the
ongoing employee coverage, tax reporting, and con tribution requirements. The coverage
in this text is meant to give a simple overview of several common options available to tax-
payers for tax-deferred retirement plans, which remain one of the best completely legal tax
shelters available.
Keogh Plans
For 2010, contributions to Keogh plans by self-employed taxpayers are generally limited to
the lesser of 20 percent of their net earned income (before the Keogh deduction) or
$49,000. A taxpayer’s net earned income includes profits from a business if a material
part of the profits from the business is from the taxpayer’s personal services. Earned
income must be reduced by one-half of the self-employment tax on the income (see
Chapter 9) to arrive at net earned income used in the pension calculation.
Self-Study Problem 3.6
a. During 2010, George (a 24-year-old single taxpayer) has a salary of $40,000,
dividend income of $14,000, and interest income of $3,000. In addition, he
has rental income of $1,000. George is covered by a qualified retirement
plan. Calculate the maximum regular IRA deduction that George is allowed.
$ ____________
b.During 2010, Irene (a single taxpayer, under 50) has a salary of $99,000 and
dividend income of $8,000. Calculate Irene’s maximum contribution to a
Roth IRA.
$ ____________
Section 3.7
Keogh (H.R. 10) Plans and Simplified Employ ee Pensions 3-21
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
EXAMPLE Danisaself-employeddoctor,andthenetearnedincomefrom
hispracticeis$125,000.UnderthetermsofhisKeoghplan,Dan
contributes 20 percent of net earned income (up to the maximum
allowable) to the pla n. Dan’s con tribution to the plan is calculated
as follows:
The lesser of 20% of $125,000 ($25,000) or $49,000
$25,000 N
Simplified Employee Pensions (SEPs)
Simplified Employee Pensions, or SEPs, are one of the most popular retirement plans for
self-employed taxpayers. The contribution limits for 201 0 are the same as the limits for
Keogh plans discussed above, that is, the lesser of 20 percent of net earned income before
the SEP deducti on or $49,000. The contributi ons are made into ‘‘SEP-IRAs,’’ which are
special IRA accounts with the higher funding limits allowed for Keogh plans. Participants
in both SEPs and Keogh plans must meet requirements for minimum age and years of ser-
vice for the participants. An employer must cover employees if the employees meet the
requirements for coverage.
To avoid penalties, taxpayers generally may not receive distributions from a Keogh plan
or SEP prior to age 59
1
/
2 and must start drawing amounts by the age of 70
1
/
2.
SECTION 3.8
QUALIFIED RETIREMENT PLANS INCLUDING
SECTION 401(K) PLANS
The tax law provides taxpayers and their employers with an incentive to plan for retirement
through qualified retirement plans. Under the tax law, favorable tax treatment is granted to
contributions, by or for employees, to qualified retirement plans. Employers may claim a
deduction in the current year for contributions to qualified retirement plans on the
employees’ behalf, while the employees d o not include the employer contributions in
income until the contributed amounts are distributed. Tax on earnings on the amounts
contributed to the plan is also deferred. This deferral of income taxation is a si gnificant
benefit to most taxpayers.
EXAMPLE In the current year, Polly’s employer makes a $2,000 contribution to a
qualified plan for Polly’s retirement. The $2,000 is deductible to the
employer in the current year and is not taxable to Polly until she
withdraws the money from the plan. Any earnings on the money con-
tributed to the plan are also taxable only upon withdrawal from the
plan (usually many years later). N
Self-Study Problem 3.7
Lewis, a self-employed individual, has net earned income of $50,000 in 2010. If
Lewis has no employees, calculate the maximum contribution to a Keogh plan
that he may deduct from his adjusted gross income.
$ ____________
3-22 Chapter 3
Business Income and Expenses, Part I
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Qualified Plans
For a retirement plan to be a qualified plan for income tax purposes, it must meet the fol-
lowing general requirements:
1. A plan must be created by an employer for the exclusive benefit of employees or their
beneficiaries.
2. The contributions and benefits under a plan must not discriminate in favor of highly
compensated employees.
3. A plan must meet certain participation and coverage requirements. The plan must pro-
vide that all employees who are 21 years old and who have completed at least 1 year
of service with the employer are eligible to participate. If the plan provides for 100
percent vesting of accrued benefits upon commencement of participation in the plan,
the 1 year of service requirement may be replaced with a requirement that the
employee has completed at least 2 years of service.
4. Minimum vesting requirements must be met with respect to both employee and
employer contributions.
5. Uniform minimum distribution rules must be met.
Types of Qualified Plans
The tax law provides for several types of qualified plans: pension plans, profit-sharing plans,
stock bonus plans, and employee stock ownership plans (ESOPs). The pension plan can take
one of two forms: the defined contribution plan or the defined benefit plan. Under a defined
contribution plan, the amount of contribution for the employee is determined by reference
to a form ula based on the employee’s current compensation. The employee’s retirement
benefits will be dependent upon the accumulated contributions and earnings in the account
at the time of retirement. Under a defined benefit plan, the future retirement benefits of the
employee are specified, and a formula is used to determine the contributions necessary to
provide for the defined benefit. Profit-sharing plans are structured to allow the employee
to share in company profits through employer contributions from su ch profits. Under a
stock bonus plan, employer contributions on behalf of the employee consist of stock of
the employer company.
EXAMPLE Heather is an employee who earned $30,000 during the current year.
Her employer contributed $1,200 (4 percent of Heather’s salary) to a
qualified retirement plan. This plan is a defined contribution plan. N
EXAMPLE Alan works for an employer whose qualified retirement plan states
that Alan will receive a retirement benefit at age 65 equal to 40 percent
of his last year’s salary. The employer must make adequate contribu-
tions to the plan to enable the stated retirement benefit to be paid
(a sufficient amount of money must be in the plan upon Alan’s retire-
ment to pay for Alan’s defined retirement benefit). This plan is a
defined benefit plan. N
Limitations on Contributions to and Benefits from Qualified Plans
Employee and employer contributions to qualified plans are subject to certain dollar or
percentage limitations. Under a defined contribution plan, the annual addition to an
employee’s account is generally not allowed to exceed the lesser of $49,000 or 25 percent
of the employee’s compensation. Under a defined benefit plan, the annual benefit payable
Section 3.8
Qualified Retirement Plans Including Section 401(k) Plans 3-23
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
to an employee upon retirement is limited to the lesser of $195,000 (for 2010) or 100 per-
cent of the employee’s average compensation for the highest three consecutive years of
employment. The operational rules for qualified pension plans and the other types of qual-
ified plans are complex.
Section 401(k) Plans
One of the more popular qualified retirement plans is the Section 401(k) plan, which per-
mits an employee to choose to receive a direct payment of compensati on in cash or to defer
the amount through an employer contribution o n behalf of the employee to a profit-
sharing or stock bonus plan. Such a plan may be structured as a salary reduction agreement.
The agreement may allow the employee to reduce his o r her compensation or forgo an
increase in compensation, with the reduction contributed to the qualified retirement
plan, thereby deferring tax on the compensation. Employees choose the percentage of
their pay which will be withheld and contributed to the plan. Some employers match
employee contributions up to a certain percentage in order to encourage participation.
For 2010, an employee may elect to make an annual contribution up to $16,500
($22,000 for taxpayers age 50 or older) to a Section 401(k) plan. The amount of any con-
tributions made to the Section 401(k) plan are also subject to the limitations applicable to
all qualified plans. Any amount contributed to the plan by the employer on behalf of the
employee is excluded from the employee’s gross income. The contributions and the earn-
ings on the amounts invested in the plan are taxable only when withdrawn.
EXAMPLE Carol, age 48, participates in a Section 401(k) plan. Carol’s salary is
$30,000 per year and she chooses to contribute 15 percent to the 401(k)
plan. The maximum amount she may contribute on a tax-deferred basis
to the Section 401(k) plan under a salary reduction agreement is $4,500
(15% $30,000, not to exceed $16,500, in 2010). N
The annual maximum ($16,500, or $22,000 if age 50 or over, in 2010) is reduced dollar
for dollar by amounts contributed as a result of the employee’s participation in other salary
reduction plans of any employer. Contributions in excess of the maximum allowed may be
subject to a 10 percent excise tax imposed on the employer. Also, if the excess contributions
are not withdrawn within a specified time period, the plan will lose its status as a qualified
arrangement.
Finally, Section 401(k) plans must meet certain requirements in addition to the general
qualification requirements for all qualified plans. The amount deferred must be 100 percent
vested and may be distributed only upon retirement, death, disability, or other separation
from service, attainment of age 59
1
/
2, or hardship. The plan must also meet stringent
anti-discrimination provisions in order to maintain its tax-deferred status.
Beginning in 2006, employers were allowed to set up Roth 401(k)s for their employees.
The amounts allowed to be set aside are t he same as for regular 401(k)s, but the dollars
paid in do not reduce the employees’ taxable income, which is similar to the tax treatment
of Roth IRAs. Withdrawals, including earnings, are generally tax free based on rules similar
to those for Roth IRA withdrawals. Roth 401(k)s are expected to be popular because they
allow a significantly higher Roth contribution than a Roth IRA and because there is no
AGI limitation, so they may be used by high-income taxpayers.
Low Income Retirement Plan Contribution Credit
Certain low-income taxpayers may claim a ‘‘Low Income Retirement Plan Contribu-
tion Credit,’’ also called the ‘‘Saver’s Credit,’’ to encourage them to participate in
3-24 Chapter 3
Business Income and Expenses, Part I
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
tax saving retirement plans, including IRAs. The credit rate is 50 percent, 20 percent,
or 10 percent depending on the taxpayer’s filing status and adjusted gross income. The
credit is a direct deduction from income taxes otherwise payable, and the cash saved
may be used to make part of the contribution to the plan. Taxpayers receive up to a
50 percent credit for contribution amounts up to $2,000 or a maximum credit of
$1,000. The credit phases out for adjusted gross income over certain income limits,
as shown below.
Joint Return Head of Household All Other Cases
Applicable
AGI Over Not Over AGI Over Not Over AGI Over Not Over Percentage
$ 0 $33,500 $ 0 $25,125 $ 0 $16,750 50
33,500 36,000 25,125 27,000 16,750 18,000 20
36,000 55,500 27,000 41,625 18,000 27,750 10
55,500 41,625 27,750 0
EXAMPLE In 2010, Teddy and Abby file a joint tax return with AGI of $27, 000.
Teddy contributes $1,500 to a Section 401(k) plan at work. Teddy and
Abby are entitled to a $750 (50% $1,500) retirement plan contribu-
tion credit. The credit is in addition to any deduction or exclusion
allowed for the contribution.
For more information regarding the calculation of the credit,
see IRS Form 8880, ‘‘Credit for Qualified Retirement Savings
Contributions.’’ N
SECTION 3.9
ROLLOVERS
In many situations, taxpayers need to transfer assets from one retirement plan to another
plan of the same or different type. For example, the taxpayer may change jobs, take early
retirement, or simply seek a better retirement fund manager. There are two ways this trans-
fer can be accomplished: (1) direct transfer, also known as a trustee-to-trustee transfer, and
(2) rollover of the distribution, in whole or in part, to an IRA or other qualified plan. There
are potentially different tax treatments for the two types of transfers.
Direct Transfers
In direct transfers, the taxpayer instructs the trustee of the retirement plan to transfer
assets to the trustee of another plan. There are no current-year tax consequences for
Self-Study Problem 3.8
During 2010, Linda, age 32, has a salary of $40,000. She participates in a
Section 401(k) plan and chooses to defer 20 percent of her compensation.
a. What is the maximum amount Linda can contribute to the Section 401(k)
plan on a tax-deferred basis?
$ ____________
b.If Linda’s salary were $125,000, instead of $40,000, what is the maximum
amount that she could contribute to the Section 401(k) plan on a tax-
deferred basis?
$ ____________
Section 3.9
Rollovers 3-25
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
this transaction. Also, there is no li mit to the number of times a taxpayer can do this in a
single tax year.
EXAMPLE Juan has $90,000 in a Section 401(k) plan with his employer. He also
has two IRAs, one with ABC Bank ($20,000) and one with XYZ Mutual
Fund ($30,000). In March of 20XX, Juan instructs ABC Bank to make a
direct transfer to XYZ Mutual Fund of all of his funds ($20,000). In
August of 20XX, Juan quits his job and instructs the trustee of the
Section 401(k) plan to transfer his $90,000 directly to XYZ Mutual
Fund. On December 31, 20XX, Juan has $140,000 in his XYZ Mutual
Fund IRA. Since these were direct transfers, there are no tax conse-
quences in the current year. N
Distribution Rollovers
In a distribution rollover, the taxpayer receives a distribution of funds from a retirement
plan and then transfers part or all of the funds to the new retirement plan trustee. The tax-
payer has a maximum of 60 days in which to transfer funds to the new plan and avoid taxes
and penalties. The 60-day rollover period may be waived in cases of casualty, disaster, and
other events beyond the reasonable control of the taxpayer such as death, disability, incar-
ceration, and postal error. The 60-day time limit is extended to 120 days for first-time
home buyers.
The major drawback to distribution rollovers is that the trustee must withhold 20 per-
cent of the amount distributed, giving the employee only 80 percent of the amount in his
or her plan. However, the employee must contribute 100 percent of the amount in the
old plan to the new trustee within the required 60-day period to avoid tax on the distri-
bution. Amounts that are not placed in a new plan within the required period are taxable
as ordinary income in the current year. Also, if the taxpayer is under 59
1
/
2 years old, the
portion of the retirement plan distribution not transferred will be subject to a 10 percent
penalty tax.
The exception to mandatory withholding is a distribution from an IRA; such distribu-
tions are not subject to the 20 percent withholding tax. Also, taxpayers are allowed only one
distribution rollover each year for transfers from one IRA to another IRA. There are many
other complex rules concerning retirement plan rollovers.
EXAMPLE Bea is 50 years old, has worked for Gold Company for 25 years, and
has $200,000 in her retirement plan. This year Gold Company is pur-
chased by Green Company. As a result of the takeover, Bea was laid
off. Bea requests a distribution of her $200,000 from Gold Company’s
retirement plan. The trustee of Gold’s retirement plan must withhold
$40,000 (20% of $200,000) from the distribution. Bea only receives
$160,000 from her retirement plan distribution. If Bea wants to roll
her funds into an IRA and avoid taxes, she must contribute $200,000,
even though she only received $160,000. If Bea has no other resour-
ces and cannot make up the $40,000, the amount not contributed to
the IRA will be taxable income to her and subject to a 10 percent
penalty. If she does make up the $40,000 from other sources, she
will receive the $40,000 withheld as a refund after her tax return is
filed. N
3-26 Chapter 3
Business Income and Expenses, Part I
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
The Wall Street Journal reported (February 19, 1998, Tax Report, Front Page) on
an IRS ‘‘blooper’’ which scared thousands of taxpayers. In early 1998, the IRS
sent out 3,000 erroneous notices, each showing a balance due of over $300 mil-
lion and stating that all or a part of the taxpayer’s expected refunds had been
withheld to offset a federal tax debt. The IRS mailed corrections and apologies
to all recipients, and blamed a ‘‘human programming error’’ for the problem.
In an even grander error reported in the Wall Street Journal (May 13, 1998,
Tax Report, Front Page), a taxpayer received a notice showing a balance due of
$40 billion plus change. Later, the IRS sent a corrected notice showing that the
taxpayer only owed about $1,500.
Self-Study Problem 3.9
Carol, age 40, has an IRA with Blue Mutual Fund. Her balance in the fund is
$150,000. She has heard good things about the management of Red Mutual
Fund, so she opens a Red Fund IRA. Carol requests her balance from the Blue
Fund on July 1, 20XX.
a. How much will Carol receive from the Blue Fund IRA?
$ ____________
b.If the funds were distributed from a qualified retirement plan (not an IRA),
how much would Carol receive?
$ ____________
c. When is the last day Carol can roll over the amount received into the Red
Fund IRA and avoid taxation in the current year?
____________
d.Assuming the funds were distributed from a qualified retirement plan, not
from an IRA, how much will Carol have to contribute to the Red Fund IRA to
avoid taxable income and any penalties?
$ ____________
KEY POINTS
Learning Objectives Key Points
LO 3.1:
Apply the tax rules for rental
property and vacation homes.
Rental income and related expenses are reported on Schedule E.
Primary rental expenses include real estate taxes, mortgage interest, insurance, commis-
sions, repairs, and depreciation.
Deductions attributable to vacation homes used primarily as personal residences are limited
to the income generated from the rental of the property.
If a residence is rented for fewer than 15 days during the year, the rental income is disre-
garded and the property is treated as a personal residence for tax purposes.
If the residence is rented for 15 days or more and is used for personal purposes for not
more than 14 days or 10 percent of the days rented, whichever is greater, the residence is
treated as a regular rental property.
If the residence is rented for 15 days or more and is used for personal purposes for more than
14 days or 10 percent of the days rented, whichever is greater, allocable rental expenses are
allowed only to the extent of rental income.
Section 3.9
Rollovers 3-27
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
LO 3.2:
Explain the treatment of passive
income and losses.
The passive loss rules define three categories of income: (1) active income, (2) portfolio
income, and (3) passive income and loss.
Normally, passive losses cannot be used to offset either active or portfolio income. Passive
losses not used to offset passive income are carried forward indefinitely.
Generally, losses remaining when the taxpayer disposes of his or her entire interest in a
passive activity may be used in full.
Under the passive loss rules, real estate rental activities are specifically defined as passive,
even if the taxpayer actively manages the property.
Individual taxpayers may deduct up to $25,000 of rental property losses against other
income if they are actively involved in the management of the property and their income
does not exceed certain limits.
Taxpayers heavily involved in real estate rental activities may qualify as running a trade or
business rather than a passive activity and fully deduct all rental losses.
LO 3.3:
Identify the tax treatment
of various deductions for adjusted
gross income, including bad debts,
cost of goods sold, and net operat-
ing losses.
Bad debts are classified as either business bad debts or nonbusiness bad debts. Debts arising
from a taxpayer’s trade or business are classified as business bad debts, while all other
debts are considered nonbusiness bad debts.
Business bad debts are treated as ordinary deductions and nonbusiness bad debts are
treated as short-term capital losses, of which only $3,000 can be deducted against ordinary
income each year.
Cost of goods sold, which is the largest single deduction for many businesses, is calculated
as follows: Beginning Inventory þ Purchases Ending Inventory.
There are two common methods of inventory valuation used by taxpayers: first in, first out
(FIFO) and last in, first out (LIFO).
A net operating loss is carried back 2 years and forward 20 years allowing taxpayers to
claim a refund of taxes in a year other than the year in which the loss occurred.
LO 3.4:
Understand the treatment
of Individual Retirement Accounts
(IRAs), including Roth IRAs.
Annual contributions to a traditional IRA are deductible and retirement distributions are tax-
able, while annual contributions to a Roth IRA are not deductible and retirement distribu-
tions are nontaxable.
Earnings in both types of IRAs are not taxable in the current year.
In 2010, the maximum annual contribution that may be made to either type of IRA is
equal to the lesser of (1) 100 percent of the taxpayer’s compensation (earned income) or
(2) $5,000 (plus an additional $5,000 which may be contributed on behalf of a spouse with
no earned income). Additional amounts are allowed for taxpayers age 50 and over.
Contributions to traditional IRAs are limited for taxpayers who are active participants in
pension plans and have income over certain limits. Contributions to Roth IRAs are limited
for taxpayers with income over certain limits, but they are not affected by taxpayer partici-
pation in other retirement plans. See text for specific rules and limits.
Money distributed from a traditional IRA is taxable as ordinary income and may be subject
to a 10 percent penalty for early withdrawal (before age 59½). Some types of early with-
drawals may be made without penalty.
A taxpayer can make tax-free withdrawals from a Roth IRA after a 5-year holding period if
the distribution is made on or after the date on which the participant attains age 59½.
Other tax-free withdrawals may also apply.
LO 3.5:
Explain the general contribution
rules for Keogh and Simplified
Employee Pension (SEP) plans.
For 2010, contributions to Keogh plans by self-employed taxpayers are generally limited to
the lesser of 20 percent of their net earned income before the Keogh deduction or $49,000.
For 2010, the contribution to a SEP is also the lesser of 20 percent of net earned income
before the SEP deduction or $49,000.
3-28 Chapter 3
Business Income and Expenses, Part I
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.