Chapter 13 Retirement Savings and Deferred Compensation Discussion Questions 1. [LO 1, LO 2] How are defined benefit plans different from defined contribution plans? How are they similar? As the name suggests, defined benefit plans spell out the specific benefit the employee will receive on retirement. In contrast, defined contribution plans specify the maximum annual contributions that employers and employees may contribute to the plan. Defined benefit plans are funded by the employer while defined contribution plans are funded by the employee. Both plans are generally classified as employer-provided qualified retirement plans and have similar rules for vesting (although the vesting rules are slightly more favorable for defined contribution plans than defined benefit plans) and required distributions. 2. [LO 1] Describe how an employee’s benefit under a defined benefit plan is computed. Defined benefit plans provide standard retirement benefits to employees based on a fixed formula. The formula to determine the standard retirement benefit is usually a function of years of service and employees’ compensation as they near retirement. However, the maximum compensation that can be taken into account for a particular year in computing the employee’s benefit is limited to the annual compensation limitation for that particular year. The annual compensation limitation is $270,000 for 2017, $275,000 for 2018, $280,000 for 2019, and $285,000 for 2020. Employees usually receive a fixed benefit for each full year of service for the employer. For example, the formula may provide a benefit of 2% for each year of service, up to a maximum of 50% (25 years of service), of the average of the employee’s three highest consecutive calendar years of compensation. The maximum annual benefit an employee can receive is the lesser of 100% of the average of three highest years of compensation, limited to the annual compensation limitation for each of the three years or $230,000 for employees who begin receiving payments in 2020. 3. [LO 1, LO 2] What does it mean to vest in a defined benefit or defined contribution plan? Vesting means that one obtains the legal right to something. An employee vests in (legally obtains the right to receive) her benefits of a defined benefit or contribution plan by meeting certain requirements set forth by her employer—usually the requirement is based on years of service. 4. [LO 1, LO 2] Compare and contrast the minimum vesting requirements for defined benefit plans and defined contribution plans. The minimum vesting requirements for a defined benefit plan are a five-year cliff or a seven-year graded schedule. These enable the employee to fully vest in her benefits after five years or over the course of seven years, respectively. The minimum vesting requirements for a defined contribution plan are a three-year cliff or a six-year graded schedule. Under these schedules, an employee fully vests after three years of service or over the course of six years, respectively. 5. [LO 1, LO 2] What are the nontax advantages and disadvantages of defined benefit plans relative to defined contribution plans? For an employee the advantage of a defined benefit plan is knowing what the payout will be at retirement given a certain amount of years of service. Thus, a defined benefit plan shifts investment risk (the risk of how an investment will perform) to the employer. However, if the employer is not able to fund or pay for the benefits, the employee may not ever receive the retirement benefits from a defined benefit plan. Many of the disadvantages of defined benefit plans are faced by the employer. Employers are required to fund (pay for) the plans. The contributions required to fund a plan are dependent upon actuarial and management estimates. This process can become very cumbersome and expensive for the employer. Also, because the employer is required to provide a certain benefit for the employee, the employer must bear the investment risk. Many employers are now moving towards defined contribution plans due to the significant nontax advantages. Employers are not required to make costly estimates to fund a contribution plan—they simply make the contribution they have committed to make. Also, employers do not bear the investment risk of the investments. For defined contribution plans, employees generally have some direction over the way in which contributions are invested and also reap all the benefits of positive market conditions or good investments. But employees also bear the investment risk associated with defined contribution plans. 6. [LO 1] Describe the maximum annual benefit that taxpayers may receive under defined benefit plans. The maximum annual benefit an employee who retires in the year 2020 can receive from a defined benefit plan is the lesser of 100% of the average of the three highest years of compensation paid to the employee or $230,000. 7. [LO 1] Describe the distribution or payout options available to taxpayers participating in qualified defined benefit plans. How are defined benefit plan distributions to recipients taxed? Once vested, employees are able to receive distributions from a defined benefit plan according to the plan’s provisions. These distributions are taxable as ordinary income in the year received. These distributions are subject to penalties if both minimum and early distribution requirements are not met. These penalties are usually of little concern since most defined benefit plans are structured to avoid them. 8. [LO 1, LO 2] Describe the minimum distribution requirements for defined benefit plans. Are these requirements typically an item of concern for taxpayers? Explain. An employee must receive distributions by the later of April 1 of the year after the year in which the employee turns 72 or when she actually retires, if later. While the requirement necessitates that she receive a distribution for the year in which she turns 72, she can defer receipt of the first payment until April 1 of the year after which she turns 72. Distribution requirements for defined benefit plans are rarely a concern, since the plans are typically structured to avoid them. 9. [LO 1, LO 2] Compare and contrast the employer’s responsibilities for providing a defined benefit plan to employees relative to providing a defined contribution plan. Employers providing a defined benefit plan to employees are required to make annual contributions to fund the plan. The employer carries the responsibility of making investments and creating sufficient funds to cover the cost of distributions to retired employees. Thus, the employer bears the investment risk associated with the investments. Employers providing defined contribution plans to employees are responsible to make up-front contributions. Separate accounts are maintained for each employee and employees are often allowed to make contributions as well. Employers do not bear the investment risk associated with the investments. 10. [LO 2] Describe how an employee’s benefit under a defined contribution plan is determined. Contributions are invested and accumulate earnings until they are distributed to the employee. Upon distribution the benefit is taxed as ordinary income. The ultimate benefit depends on the amount of employer contributions (and the employee’s vesting in the employer contributions), employee contributions, and the earnings on the contributions. 11. [LO 2] Is there a limit to how much an employer and/or employee may contribute to an employee’s defined contribution account(s) for the year? If so, describe the limit. Yes, there is a limit to how much an employer and/or employee may contribute to an employee’s defined contribution account(s) for the year. For 2020, the combined contributions to an employee’s defined contribution plan(s) made by both the employer and employee are limited to the lesser of $57,000 or 100% of the employee’s compensation for the year ($63,500 for employees 50 years old by year end). The employee’s contribution is limited to $19,500 for 401(k) and 403(b) plans ($26,000 for employees who are at least 50 years old at the end of the year). 12. [LO 2] Cami (age 52 and married) was recently laid off as part of her employer’s reduction in force program. Cami’s annual AGI was usually around $50,000. Shortly after Cami’s employment was terminated, her employer distributed the balance of her employer-sponsored 401(k) account to her. What could Cami do to avoid being assessed the 10 percent early distribution penalty? Cami could “roll over” (contribute) the full 401(k) proceeds to an individually managed retirement plan such as an IRA or a Roth IRA. Because she is under age 55, if she does not roll over the proceeds, she will be taxed on the full distribution amount and she will be required to pay a 10% penalty on the full proceeds. 13. [LO 2] When many employees begin to receive defined contribution plan distributions without penalty? Employees may begin to receive distributions when they reach the age of 59 ½ or 55 if they are retired or let go by their employer. 14. [LO 2] Describe the circumstances under which distributions from defined contribution plans are penalized. What are the penalties? If an employee receives a distribution too early or too late, the employee is penalized. A distribution is considered to be received too early if it is received before the individual reaches 59 ½ years of age or 55 if retired or let go by their employer. The penalty on an early distribution is 10% of the entire distribution amount. A distribution is subject to penalty if it is received too late or is insufficient in amount. A minimum distribution penalty applies when taxpayers don’t receive the required minimum distribution for a particular year. The required minimum distribution is based on the age of the taxpayer and tables provided in the Treasury Regulations. The minimum distributions must be received by later of April 1 of the year after the year in which the employee turns 72 or when the employee actually retires. When an employee fails to receive the minimum distribution, the employee is taxed at 50% on the difference between the required distribution and the amount actually distributed. 15. [LO 2] {Research} Brady Corporation has a profit-sharing plan that allocates 10 percent of all after-tax income to employees. The profit sharing is allocated to individual employees based on relative employee compensation. The profit-sharing contributions vest to employees under a six-year graded plan. If an employee terminates his or her employment before fully vesting, the plan allocates the forfeited amounts among the remaining participants according to their account balances. Is this forfeiture allocation policy discriminatory, and will it cause the plan to lose its qualified status? (Hint: Use Rev. Rul. 81-10 to help formulate your answer). §401(a)(4) dictates that a profit-sharing plan will not qualify if it discriminates in favor of officers, or highly compensated employees. The issue addressed is whether or not the above profit-sharing plan is discriminatory. Rev. Rul. 81-10 explains that a profit-sharing plan will not be disqualified “merely because it provides for the allocation of forfeitures arising from termination of service among the remaining participants on the basis of their account balances.” It appears that this profit sharing will not cause the plan to lose its qualified status. 16. [LO 2] What does it mean if an employer “matches” employee contribution to 401(k) plans? When an employer matches an employee’s contribution, the employer contributes to the employee’s plan based on how much the employee contributes. The matching policy is frequently described as a multiple of what the employee contributes to the plan. If, for example, an employee contributes $1,000 to a 401(k) plan, the employer may offer to match this contribution 2 to 1 for a $2,000 contribution from the employer. In this case, the employer and employee contributions sum to $3,000. 17. [LO 2] {Planning} What nontax factor(s) should an employee consider when deciding whether and to what extent to participate in an employer’s 401(k) plan? Nontax factors to be considered in the decision to participate in an employer’s 401(k) plan include any matching programs the employer may have in place, when an employee may need funds distributed, and how funds contributed to the 401(k) will be invested. 18. [LO 2] What are the differences between a traditional 401(k) and a Roth 401(k) plan? Taxpayers contribute “after-tax” dollars to Roth 401(k) accounts. That is, their contributions are not deductible. However, distributions from Roth 401(k) plans are not taxable. In contrast, employees contribute “before-tax” dollars to traditional 401(k) plans. That is, these contributions are deductible and distributions are taxable. 19. [LO 2] Can employers match employee contributions to Roth 401(k) plans? Explain. Employers are not allowed to contribute to an employee’s Roth 401(k) plan. They may contribute to the employee’s traditional 401(k) plan. 20. [LO 2] Describe the annual limitation on employer and employee contributions to traditional 401(k) and Roth 401(k) plans. The combined contributions made by an employer and employee to an employee’s 401(k) plan (Roth or traditional) is limited to the lesser of $57,000 or 100% of the employee’s compensation for the year. In 2020, the employee’s contribution is limited to $19,500 ($26,000 if age 50 by the end of the year). Thus, if an employee contributes $19,500 to her 401(k) plan (Roth or traditional), the employer’s contribution to the employee’s traditional 401(k) plan is limited to $37,500 ($57,000 – $19,500). If the employee and employer make the maximum contributions, taxpayers under 50 years of age could have $57,000 contributed to their accounts and taxpayers 50 years of age or older could have $63,500 contributed to their accounts. Employers may not contribute to an employee’s Roth 401(k). 21. [LO 2, LO 3] When a company is limited by the tax laws in the amount it can contribute to an employee’s 401(k) plan, what will it generally do to make the employee whole? Is this likely an issue for rank-and-file employees? Why or why not? Employers offering matching opportunities for employee contributions to 401(k) plans are often unable to make a full match for highly compensated employees due to the $57,000 limitation (the combined total contribution made by an employee and the employer is limited to $57,000). In order to make these employees whole, companies offer supplemental nonqualified deferred compensation plans. This issue is not likely to matter for rank-and-file employees because employers are less likely to be constrained by the $57,000 limit on matching employee contributions to 401(k) plans. 22. [LO 2] {Planning} From a tax perspective, how would taxpayers determine whether they should contribute to a traditional 401(k) or a Roth 401(k)? Roth 401(k) plans always generate after-tax rates of return equal to before-tax rates of return. Thus, traditional 401(k) plans only generate better rates of return when the employee’s tax rate is higher at the time of contribution than at the time of distribution. If the employee’s tax rate at the time of contribution and distribution are the same, the after-tax rates of return of the Roth 401(k) and the traditional 401(k) will be the same. In other words, as a general rule traditional plans are typically better if an employee’s tax rate will decrease upon retirement and Roth plans are typically better if an employee’s tax rate will increase upon retirement. 23. [LO 2] Could a taxpayer contributing to a traditional 401(k) plan earn an after-tax return greater than the before-tax return? Explain. If an individual contributes to a traditional 401(k) plan and later receives a distribution when she is paying tax at a lower marginal tax rate, she can earn an after-tax rate of return greater than the before-tax rate of return. This occurs because contributions are deductible and provide a tax benefit at a high tax rate and distributions are taxable but provide a tax cost at a low rate. 24. [LO 2, LO 3] Explain the tax similarities and differences between qualified defined contribution plans and nonqualified deferred compensation plans from an employer’s perspective. Similarities Employers: Employers deduct amounts they pay for qualified and nonqualified plans. Both plans provide deferred compensation or benefits to the employee. Dissimilarities Employers: Nonqualified plans are not subject to the same restrictive requirements pertaining to qualified plans, so employers may discriminate in terms of who they allow to participate in the plan. In fact, employers generally restrict participation in nonqualified plans to more highly compensated employees. Also, employers are not required to “fund” nonqualified plans. That is, employers are not required to formally set aside and accumulate funds specifically to pay the deferred compensation obligation when it comes due. Rather, employers typically retain funds deferred by employees under the plan, use the funds for business operations, and pay the deferred compensation out of their general funds when it comes due. 25. [LO 2, LO 3] Explain the tax similarities and differences between qualified defined contribution plans and nonqualified deferred compensation plans from an employee’s perspective. Similarities Employees: Just as with defined contribution plans, employee contributions to nonqualified deferred compensation plans (NQDC) reduce an employee’s taxable income in the year of contribution. Also, just as with qualified plans, employees are not taxed on the balance in their account until they receive distributions. Finally, like distributions from qualified plans, distributions from nonqualified deferred compensation plans are taxed as ordinary income. Dissimilarities Employees: Unlike qualified defined contribution plans, there is no legal limitation on the amount employees can put into a nonqualified deferred compensation account. Also, the penalty provisions for taking early (or late) distributions of qualified defined contribution plans is different than penalty provisions that may apply to nonqualified deferred compensation plan distributions. 26. [LO 2, LO 3] Explain the nontax similarities and differences between qualified defined contribution plans and nonqualified deferred compensation plans from an employer’s perspective. Qualified plans are similar to nonqualified plans in that they both provide compensation to employees in years after they earn it. Employers may discriminate in terms of who they allow to participate in a nonqualified deferred plan but they may not discriminate when they provide a qualified plan. The employer typically makes annual contributions to the defined contribution plan but is not required to fund nonqualified plans. 27. [LO 2, LO 3] Explain the nontax similarities and differences between qualified defined contribution plans and nonqualified deferred compensation plans from an employee’s perspective. The two types of plans are similar in that they invest (or defer receiving) compensation for a future return. However, the future return is frequently based on deemed, rather than actual, investment choices and the employee becomes an unsecured creditor of the employer. If the employer doesn’t have the funds, the employee may not receive benefit from a nonqualified plan. Because the funds in a defined contribution plan are set aside for the taxpayer in a separate account outside the control or ownership of the employer, the employee is not an unsecured creditor of the company. 28. [LO 3] {Planning} From a tax perspective, what issues does an employee need to consider in deciding whether to defer compensation under a nonqualified deferred compensation plan or to receive it immediately? An employee should take into account projected tax rates at the time of contribution (deferral) and at the time of receipt of payments from an NQDC. The after-tax rate of return will be dependent upon the marginal tax rate. As discussed in the chapter, assuming equal before-tax rates of return, if the taxpayer’s marginal tax rates are equal at the time of deferral and at the time the employee receives the deferred compensation, the after-tax rate of return will equal the before-tax rate of return. If the tax rate is higher at the time of contribution than at the time of distribution, then the after-tax rate of return will exceed the before-tax rate of return. Finally, if the tax rate at the time of contribution is lower than at the time of distribution, then the after-tax rate of return will be lower than the before-tax rate of return. 29. [LO 3] {Planning} From a nontax perspective, what issues does an employee need to consider in deciding whether to defer compensation under a nonqualified deferred compensation plan or to receive it immediately? Employees should consider whether or not the benefits to be received from the nonqualified deferred compensation plan are adequate to meet their expected costs upon retirement. They should also consider whether they can afford to defer current salary and the expected rate of return of the deferred salary and the rate of return they would receive if they were to receive the salary now and invest it. Finally, employees should consider the financial stability of their employer because employers are not required to fund nonqualified plans. 30. [LO 3] What are reasons why companies provide nonqualified deferred compensation plans for certain employees? Employers may provide nonqualified deferred compensation as part of a compensation package to attract prospective executives and other employees. They may provide plans because they can earn more on the deferred compensation than they are required to pay to employees. They may also provide plans to make highly compensated employees whole in terms of matching contributions to qualified retirement plans (because employers may not be able to contribute the full matching percentage to the highly compensated employees due to tax law limitations on contributions). 31. [LO 3] Are companies allowed to decide who can and cannot participate in nonqualified deferred compensation plans? Briefly explain. Yes, companies are allowed to decide who can and cannot participate in a nonqualified deferred compensation plan. In fact, NQDCs are typically used to discriminate in favor of highly compensated employees because employers are often unable to match contributions made to defined contribution plans due to the contribution limitations. 32. [LO 1, LO 2, LO 3] How might the ultimate benefits to an employee who participates in a qualified retirement plan of a company differ from the ultimate benefits to an employee who participates in a nonqualified deferred compensation plan of the company if the company experiences bankruptcy before the employee is scheduled to receive the benefits? Employers are required to carry a separate account for each employee participating in a defined contribution plan. Amounts contributed to an employee’s account and all gains or losses attributable to the account belong to the employee. Employers are not required to fund nonqualified deferred compensation plans. As a result, if an employer falls into bankruptcy before an employee receives distributions from a nonqualified deferred compensation plan, as an unsecured creditor of the employer, the employee is unlikely to recover the amount of the deferred compensation. 33. [LO 4] Deductions for traditional IRAs and contributions to Roth IRAs are phased out based on modified AGI (MAGI). In general terms, how does MAGI for purposes of determining the traditional IRA deduction differ from AGI and how does it differ from MAGI for purposes of determining whether a taxpayer can contribute to a Roth IRA? In general MAGI for purposes of determining the traditional IRA deduction is different from AGI because it is AGI disregarding the deduction for the IRA itself and certain other items. MAGI for Roth IRA purposes is the same as MAGI for traditional IRA purposes except that MAGI for Roth IRA purposes excludes income recognized on a traditional to Roth IRA conversion. 34. [LO 4] What are the primary tax differences between traditional IRAs and Roth IRAs? Traditional IRA contributions are deductible and distributions when received are taxable (assuming all deductible contributions, otherwise part of the traditional IRA distributions are taxable). Roth IRA contributions are not deductible and qualified distributions when received are not taxable. Minimum distributions are not required for Roth IRAs but they are required for traditional IRAs. 35. [LO 4] {Planning} Describe the circumstances in which it would be more favorable for a taxpayer to contribute to a traditional IRA rather than a Roth IRA, and vice-versa. In general, a traditional IRA will typically provide a better after-tax rate of return when tax rates are expected to decline in the future. A Roth IRA will generally provide a better after-tax rate of return when tax rates are expected to increase in the future. If the tax rates are expected to remain the same, the after-tax rate of return will be the same for both types of IRAs. 36. [LO 4] What are the requirements for a taxpayer to make a deductible contribution to a traditional IRA? Why do the tax laws impose these restrictions? To make a deductible contribution to a traditional IRA the taxpayer must (1) not be a participant in an employer-sponsored retirement plan or (2) if they are participating in an employee-sponsored retirement plan, they must have income below a certain threshold. IRAs are meant to help persons that are unable to participate in an employer-sponsored program or that have relatively low levels of income. 37. [LO 4] What is the limitation on a deductible IRA contribution for 2020? For those not already participating in an employer-sponsored retirement plan, deductible contributions to an IRA are limited to $6,000 a year or earned income if it is less. Taxpayers who have reached the age of 50 by year end are able to contribute an additional $1,000. A taxpayer already participating in an employer-sponsored program may also make deductible contributions of the same amount if her AGI falls below a certain threshold. The $6,000 (or $7,000) deductible amount is phased out for taxpayers whose AGI exceeds the threshold amount. 38. [LO 4] Compare the minimum distribution requirements for traditional IRAs to those of Roth IRAs. In regards to traditional IRAs, taxpayers are subject to the same minimum distribution requirements as traditional 401(k) plans. They must begin receiving distribution by the later of April 1 of the year after the year in which the taxpayer turns 72 or when she retires. The minimum amount of the distribution is determined by using a table provided in the Treasury Regulations and is based upon the taxpayer’s age and account balance. Taxpayers are not ever required to receive minimum distributions from Roth IRAs. 39. [LO 4] How are qualified distributions from Roth IRAs taxed? How are nonqualified distributions taxed? Qualified distributions from a Roth IRA are not taxable. Nonqualified distributions are taxed to the extent that they are made from the earnings of the account. Nonqualified distributions of account earnings are also subject to a 10 percent penalty unless the taxpayer is at least 59 ½ years of age at the time of distribution. Contributions to a Roth IRA are from after-tax dollars (non-deductible) and can always be recovered tax free. Nonqualified distributions are considered to first come from contributions and then earnings. 40. [LO 4] Explain when a taxpayer will be subject to the 10 percent penalty when receiving distributions from a Roth IRA. Taxpayers who receive a distribution of earnings from a Roth IRA are subject to the 10% penalty on the earnings unless the taxpayer is 59 ½ years of age at the time of the distribution or the taxpayer meets one of the other exceptions provided in §72(t)(2). Nonqualified distributions are any distributions from the Roth IRA if the taxpayer has not had the Roth IRA account open for at least five years. If the Roth account has been open for five years, all distributions other than distributions (1) made on or after the date the taxpayer reaches 59 ½ years of age, (2) made to a beneficiary (or to the estate of the taxpayer) on or after the death of the taxpayer, (3) attributable to the taxpayer being disabled, or (4) used to pay qualified acquisition costs for first-time homebuyers (limited to $10,000) are considered to be disqualified distributions. 41. [LO 4] Is a taxpayer who contributed to a traditional IRA able to convert the funds to a Roth IRA? If yes, explain the tax consequences of the conversion. Yes, taxpayers can convert deductible contributions made to a traditional IRA into a Roth IRA. They can do this by having the funds directly transferred from the traditional to the Roth IRA (taxpayer does not receive a distribution of the funds) or the taxpayer can roll over the funds from the traditional IRA to the Roth IRA by receiving a distribution from the traditional IRA and then contributing the funds to the Roth IRA within 60 days of receiving the contribution. With either a direct transfer or a rollover, the entire amount taken from the traditional IRA is taxed at ordinary rates. A direct transfer is not subject to the 10% early distribution penalty because the funds are not distributed. In the case of a rollover, the distribution amount is not subject to the 10% penalty so long as the taxpayer contributes the full amount taken out of the traditional IRA to a Roth IRA within 60 days of taking it out of the traditional IRA. Any amount not rolled into the Roth IRA is generally subject to the 10% early distribution penalty if the taxpayer is not 59 ½ years of age at the time of the distribution. 42. [LO 4] Assume a taxpayer makes a nondeductible contribution to a traditional IRA. How does the taxpayer determine the taxability of distributions from the IRA on reaching retirement? When a taxpayer receives a partial distribution from an IRA containing both deductible and nondeductible contributions, the nontaxable portion of the distribution is determined by multiplying the ratio of the nondeductible contribution over the entire balance in the account (nondeductible contributions / entire account balance) by the amount of the distribution. This information is reported on Form 8606, Nondeductible IRAs. 43. [LO 4] When a taxpayer receives a nonqualified distribution from a Roth IRA, is the entire amount of the distribution treated as taxable income? No, only the portion of a nonqualified distribution attributable to the earnings from contributions is taxable (this portion is also generally penalized at a 10% rate unless the taxpayer is at least 59 ½ at the time of the distribution). Distributions are considered to come first from contributions and then from earnings. 44. [LO 5] What types of retirement plans are available to self-employed taxpayers? Two of the more common plans for the self-employed are the SEP IRA and individual (or “self-employed”) 401(k). Other plans such as Simple IRA plans are also available to self-employed taxpayers although we don’t discuss details of these plans in the chapter. 45. [LO 5] Compare and contrast the annual limitations on deductible contributions to SEP IRAs and individual 401(k) accounts for self-employed taxpayers. The contribution limitation on a SEP IRA for 2020 is the lesser of $57,000 or 20% of Schedule C net income minus the deduction for half of self-employment taxes paid. The contribution limitation on individual 401(k) accounts is the lesser of $57,000 or 20% of Schedule C net income minus the deduction for half of self-employment taxes paid plus $19,500 (the employee’s contribution). Taxpayers 50 years old and older may contribute an additional $6,500 “catch up” contribution above and beyond these limitations (the catch up is not available for SEP IRAs). Thus, taxpayers who are at least 50 years of age at the end of the year can contribute up to $63,500 to their individual 401(k) accounts. In any event, taxpayers are not allowed to contribute more than their net Schedule C income minus the deduction for self-employment taxes no matter their age at year end. 46. [LO 5] {Planning} What are the nontax considerations for self-employed taxpayers deciding whether to set up a SEP IRA or an individual 401(k)? Sole proprietors with employees providing a SEP IRA must contribute to the employees’ SEP IRA accounts based on their overall compensation from the business. This can be a heavy burden for a sole proprietor and should be considered before setting up a SEP IRA. The individual 401(k) is not available for sole proprietors with employees, so providing benefits to employees under the plan is not a concern. However, the administrative burden of establishing, operating, and maintaining a plan is much higher for a 401(k) plan than the other self-employed plans such as SEP IRAs. 47. [LO 6] What is the saver’s credit, and who is eligible to receive it? The saver’s credit is a credit provided for an individual’s elective contributions of up to $2,000 to any qualified retirement plan multiplied by a percentage provided by the IRS and dependent upon AGI. The credit is in addition to any deduction the taxpayer may have been able to take as a result of the contribution. The credit is only available for taxpayers who are 18 years of age or older, not full-time students during the year (full-time student during five calendar months during taxpayer’s tax year), and not claimed as dependents on another taxpayer's return. 48. [LO 6] What is the maximum saver’s credit available to taxpayers? What taxpayer characteristics are relevant to the determination? The maximum saver’s credit available to taxpayers is $1,000. It is calculated by multiplying the taxpayer’s contribution, up to a maximum of $2,000, by the applicable percentage depending on the taxpayer’s filing status and AGI. Also, the credit is restricted to individuals who are 18 years of age or older and who are not full-time students or claimed as dependents on another taxpayer’s return. The saver’s credit is nonrefundable. 49. [LO 6] How is the saver’s credit computed? The saver’s credit is calculated by multiplying the taxpayer’s contribution (only up to $2,000) by an applicable percentage (10%, 20%, or 50%) provided by the IRS and based on the taxpayer’s filing status and AGI. Also, the credit is restricted to individuals who are 18 years of age or older and who are not full-time students (full-time students during at least five calendar months during taxpayer’s tax year) or claimed as dependents on another taxpayer’s return. Problems 50. [LO 1] Javier recently graduated and started his career with DNL Inc. DNL provides a defined benefit plan to all employees. According to the terms of the plan, for each full year of service working for the employer, employees receive a benefit of 1.5 percent of their average salary over their highest three years of compensation from the company. Employees may accrue only 30 years of benefit under the plan (45 percent). Determine Javier’s annual benefit on retirement, before taxes, under each of the following scenarios: a. Javier works for DNL for three years and three months before he leaves for another job. Javier’s annual salary was $55,000, $65,000, $70,000, and $72,000 for years 1, 2, 3, and 4 respectively. DNL uses a five-year cliff vesting schedule. b. Javier works for DNL for three years and three months before he leaves for another job. Javier’s annual salary was $55,000, $65,000, $70,000, and $72,000 for years 1, 2, 3, and 4 respectively. DNL uses a seven-year graded vesting schedule. c. Javier works for DNL for six years and three months before he leaves for another job. Javier’s annual salary was $75,000, $85,000, $90,000, and $95,000 for years 4, 5, 6, and 7 respectively. DNL uses a five-year cliff vesting schedule. d. Javier works for DNL for six years and three months before he leaves for another job. Javier’s annual salary was $75,000, $85,000, $90,000, and $95,000 for years 4, 5, 6, and 7 respectively. DNL uses a seven-year graded vesting schedule. e. Javier works for DNL for 32 years and three months before retiring. Javier’s annual salary was $175,000, $185,000, $190,000, and $195,000 for his final four years of employment. Note that in the year he retired he didn't work for the entire year, so he received only a portion of the annual salary for that year. a. Only the three full years Javier worked for DNL count toward his retirement benefit. Because DNL uses a five-year cliff vesting schedule and because Javier worked for DNL for less than five full years, Javier does not vest in any of his retirement benefit. So, his before-tax annual benefit from DNL on retirement is $0. b. Only the three full years Javier worked for DNL count toward his retirement benefit. Because DNL used a seven-year graded schedule, Javier has vested in 20% of his total benefit. Javier has worked three full years and is eligible to receive 4.5% (3 × 1.5%) of the average of his three highest years of compensation. The average of his three highest years of salary is $63,333 [(55,000+65,000+70,000) / 3] (he only earned one-fourth his salary in year 4). His annual before-tax benefit is $570 ($63,333 × 4.5% × 20%). c. Javier is eligible to count six full years of service towards his retirement benefit. Because DNL uses a 5-year cliff schedule and Javier has worked more than five years, he has vested 100% in his total retirement benefit. He will receive 9% (6 × 1.5%) of $83,333, the average of his three highest years of salary [(75,000+85,000+90,000)/3] (he earned only one-fourth of his salary in year 7). His annual before-tax benefit will be $7,500 (9% × $83,333). d. Javier may count six full years of service with DNL towards determining his retirement benefit with DNL. Because DNL uses a seven-year graded vesting schedule, Javier has vested in 80% of his total benefit. His total benefit is 1.5% a year of the average of his three highest years of compensation. Because Javier has worked for six full years, he is eligible for 9% of his average salary for his three highest years of compensation. In this case, his highest salary came in years 4 – 6 (he only earned one-fourth of his $95,000 salary in year 7). His average salary over this period is $83,333 [(75,000 + 85,000 + 90,000) / 3]. So, his annual before tax benefit from DNL is $6,000 (i.e., $83,333 × 9% × 80%). e. Javier has vested 100% in his total retirement benefit and is eligible for the maximum 45% (1.5% × 30 years) benefit of the average of his three highest years of salary. The average of his three highest years of salary is $183,333 [(175,000+185,000+190,000) / 3] [in his last year he only worked for three months so he earned only $48,750 (3/12 × $195,000) that year]. Javier’s before-tax benefit is $82,500 ($183,333 × 45%). Note that Javier’s annual salary for his last year of employment was high, but because he worked for only one quarter of the year, he only earned $48,750. That amount was therefore not included in his highest three years of compensation computation. 51. [LO 1] Alicia has been working for JMM Corp. for 32 years. Alicia participates in JMM’s defined benefit plan. Under the plan, for every year of service for JMM, she is to receive 2 percent of the average salary of her three highest consecutive calendar years of compensation from JMM. She retired on January 1, 2020. Before retirement, her annual salary was $570,000, $600,000, and $630,000 for 2017, 2018, and 2019. What is the maximum benefit Alicia can receive in 2020? $176,000. Before considering any benefit limitation, Alicia is entitled to receive 64% (32 years × 2% per year) of her average salary for her three highest years of compensation. The average of Alicia’s three highest consecutive calendar years of compensation is $600,000 [($570,000+$600,000+$630,000)/3]. However, only compensation up to the annual limit for each year can be taken into account for purposes of determining her annual benefit. Her average three highest consecutive calendar years of compensation under the limitation is $275,000 [($270,000 for 2017 + $275,000 for 2018 + $280,000 for 2019)/3]. Consequently, she can receive the lesser of $176,000 ($275,000 × 64%) from JMM or $230,000 (the maximum benefit for 2020. Consequently, the maximum annual benefit Alicia can receive in 2020 is $176,000. 52. [LO 2] Allie received a $50,000 distribution from her 401(k) account this year that she established while working for Big Stories, Inc. Assuming her marginal ordinary tax rate is 24 percent, how much tax and penalty will Allie pay on the distribution under the following circumstances? a. Allie is 45 and still employed with Big Stories Inc. b. Allie is 56 and was terminated from Big Stories Inc. this year. c. Allie is 67 and retired. a. $17,000. Allie will be taxed at 24% on the $50,000 withdrawal. Consequently, she will pay $12,000 in taxes (50,000 × 24%). In addition, she must pay a 10% early distribution penalty on the $50,000 withdrawal ($50,000 × 10% = $5,000 penalty). b. $12,000. Allie will be taxed at 24% on the $50,000 withdrawal. Consequently, she will pay $12,000 in taxes (50,000 × 24%). She is not subject to the 10% early distribution penalty on the $50,000 withdrawal because she is over the age of 55 and has separated from service from Big Stories, Inc. c. $12,000. Allie will be taxed at 24% on the $50,000 withdrawal. Consequently, she will pay $12,000 in taxes (50,000 × 24%). She is not subject to the 10% early distribution penalty on the $50,000 withdrawal because she is over the age of 59 ½. 53. [LO 2] {Tax Forms} Tim has worked for one employer his entire career. While he was working, he participated in the employer’s defined contribution plan [traditional 401(k)]. At the end of 2020, Tim retires. The balance in his defined contribution plan is $2,000,000 at the end of 2019. a. What is Tim’s required minimum distribution for 2020 that must be distributed in 2021 if he is 68 years old at the end of 2020? b. What is Tim’s required minimum distribution for 2020 if he turns 72 during 2020? When must he receive this distribution? c. What is Tim’s required minimum distribution for 2020 that must be distributed in 2021 if he turns 75 years old in 2020? d. Assuming that Tim is 76 years old at the end of 2020 and his marginal tax rate is 32 percent, what amount of his distribution will he have remaining after taxes if he receives only a distribution of $50,000 for 2020? e. {Forms}. Complete Form 5329, page 2, to report the minimum distribution penalty in part (d). Use the most recent form available. a. $0. The minimum distribution requirements for defined contribution plans require employees to begin receiving distributions from the plan by the later of (1) April 1 of the year after the year in which the employee reaches 72 years of age or (2) the year after the year in which the employee actually retires. In this situation, Tim has not yet reached 72 years of age so he is not required to receive any distributions from the plan for 2020 in 2021. That is, his required minimum distribution for 2020 is $0. b. $78,200. Because he turns 72 during 2020, Tim is required to receive a minimum distribution for 2020. Tim’s required minimum distribution for 2020 is based on the balance of his 401(k) account at the end of 2019 ($2,000,000) multiplied by the applicable percentage in the Uniform Lifetime Table. Because he is 72 years old at the end of 2020, the applicable percentage is 3.91%. Consequently, Tim’s required minimum distribution for 2020 is $78,200 ($2,000,000 × 3.91%). Note that even though this is a required minimum distribution for 2020, Tim is not required to receive this distribution until April 1, 2021. c. $87,400. The required minimum distribution requirements for defined contribution plans require employees to begin receiving distributions from the plan by the later of (1) April 1 of the year after the year in which the employee reaches 72 years of age or (2) April 1 of the year after the year in which the employee retires. In this case (2) applies to Tim. Because Tim retired at the end of 2020, he must receive a require minimum distribution (for 2020) in 2021. The amount of the distribution is calculated using the Uniform Lifetime Table. Because Tim is 75 at the end of 2020, the table indicates that he must receive a distribution for 2020 of 4.37% of his account balance at the end of 2019. His account balance at the end of 2019 was $2,000,000. Thus, Tim’s required minimum distribution for 2020 is $87,400 ($2,000,000 × 4.37%). Tim must receive the distribution by April 1, 2021 to avoid penalty. This distribution is taxed as ordinary income to Tim. d. $13,600. The required minimum distribution for defined contribution plans require employees to begin receiving distributions from the plan by the later of (1) April 1 of the year after the year in which the employee reaches 72 years of age or (2) April 1 of the year after the year in which the employee retires. In this situation, (2) applies to Tim. The amount of the distribution is calculated using the Uniform Lifetime Table. Because Tim is 76 at the end of 2020, the table indicates that he must receive a distribution for 2020 of 4.54% of his account balance at the end of 2019. His account balance at the end of 2019 was $2,000,000. Thus, Tim’s required minimum distribution for 2020 is $90,800 ($2,000,000 × 4.54%). However, his actual distribution for 2020 was only $50,000. Consequently, he must pay a 50% penalty tax on $40,800 ($90,800 – $50,000); the amount he was required to receive and did not. So, Tim must pay income tax of $16,000 on the $50,000 distribution he did receive ($50,000 × 32%) and an $20,400 penalty tax on the amount he did not receive ($40,800 × 50%). In total, Tim must pay $36,400 in taxes ($16,000 + $20,400) on a $50,000 distribution. This leaves him with $13,600 after taxes ($50,000 – $36,400). Thus, this distribution would be effectively taxed at a marginal tax rate of 72.8% ($36,400/50,000). This is a strong incentive to receive the required minimum distributions. e. 54. [LO 2] Matthew (48 at year-end) develops cutting-edge technology for SV Inc., located in Silicon Valley. In 2020, Matthew participates in SV’s money purchase pension plan (a defined contribution plan) and in his company’s 401(k) plan. Under the money purchase pension plan, SV contributes 15 percent of an employee’s salary to a retirement account for the employee up to the amount limited by the tax code. Because it provides the money purchase pension plan, SV does not contribute to the employee’s 401(k) plan. Matthew would like to maximize his contribution to his 401(k) account after SV’s contribution to the money purchase plan. a. Assuming Matthew’s annual salary is $400,000, what amount will SV contribute to Matthew’s money purchase plan? What can Matthew contribute to his 401(k) account in 2020? b. Assuming Matthew’s annual salary is $240,000, what amount will SV contribute to Matthew’s money purchase plan? What can Matthew contribute to his 401(k) account in 2020? c. Assuming Matthew’s annual salary is $60,000, what amount will SV contribute to Matthew’s money purchase plan? What amount can Matthew contribute to his 401(k) account in 2020? d. Assume the same facts as part (c), except that Matthew is 54 years old at the end of 2020. What amount can Matthew contribute to his 401(k) account in 2020? a. For 2020, the sum of employer and employee contributions that can be made to an employee’s defined contribution plan(s) is the lesser of $57,000 or 100% of the employee’s compensation for the year. Here, 100% of Matthew’s compensation for the year is $400,000. Therefore, contributions to Matthew’s defined contribution accounts for 2020 are limited to $57,000. Under its plan, SV would contribute $60,000 to Matthew’s money purchase pension plan ($400,000 × 15%). However, the tax code limits the contribution to $57,000. So, SV will contribute $57,000 to Matthew’s money purchase pension plan. Because the limit on contributions to Matthew’s defined contribution plans has been reached by SV’s $57,000 contribution, Matthew is not allowed to contribute anything to his 401(k) account in 2020. b. For 2020, the sum of employer and employee contributions that can be made to an employee’s defined contribution plan(s) is the lesser of $57,000 or 100% of the employee’s compensation for the year. Here, 100% of Matthew’s compensation for the year is $240,000. So, contributions to Matthew’s defined contribution accounts for 2020 are limited to $57,000. Under its plan, SV contributes $36,000 to Matthew’s money purchase pension plan ($240,000 × 15%). Because the limit on overall contributions to Matthew’s defined contribution plans is $57,000 and because the limit on contributions by an employee to a 401(k) plan is $19,500, Matthew may still contribute $19,500 to his 401(k) account in 2020. This means a total of $55,500 would be contributed to his account ($36,000 + $19,500). c. $28,500. For 2020, the sum of employer and employee contributions that can be made to an employee’s defined contributions plan(s) is the lesser of $57,000 or 100% of the employee’s compensation for the year. Here, 100% of Matthew’s compensation for the year is $60,000, thus, contributions to his defined contribution accounts for the year are limited to $57,000. Under its plan SV contributes $9,000 (15% × $60,000). Employees are limited to contributing $19,500 for 2020, thus, Matthew is allowed to contribute an additional $19,500 for a total combined employer and employee contribution of $28,500 (19,500 + 9,000). d. Because Matthew is 50 years old or older at the end of the year, he is allowed to contribute an additional $6,500 to his 401(k) account above and beyond the limitations described in explanation c. So, Matthew can contribute $26,000 to his 401(k) plan in 2020. Matthew’s $26,000 ($19,500 + $6,500) contribution plus SV’s $9,000 contribution adds up to a total of $35,000 in contributions to Matthew’s 401(k) account for the year. 55. [LO 2] {Planning} In 2020, Maggy (34 years old) is an employee of YBU Corp. YBU provides a 401(k) plan for all its employees. According to the terms of the plan, YBU contributes 50 cents for every dollar the employee contributes. The maximum employer contribution under the plan is 15 percent of the employee’s salary (if allowed, YBU contributes until the employee has contributed 30 percent of her salary). a. Maggy worked for YBU Corporation for 3½ years before deciding to leave effective July 1, 2020. Maggy’s annual salary during this time was $45,000, $52,000, $55,000, and $60,000 (she only received half of her $60,000 2020 salary). Assuming Maggy contributed 8 percent of her salary (including her 2020 salary) to her 401(k) account, what is Maggy’s vested account balance when she leaves YBU (exclusive of account earnings)? Assume YBU uses three-year cliff vesting. b. Using the same facts in part (a), assume YBU uses six-year graded vesting. What is Maggy’s vested account balance when she leaves YBU (exclusive of account earnings)? c. Maggy wants to maximize YBU’s contribution to her 401(k) account in 2020. How much should Maggy contribute to her 401(k) account assuming her annual salary is $100,000 (and assuming she works for YBU for the entire year)? d. Using the same facts in part (c), assume Maggy is 55 years old rather than 34 years old at the end of the year. How much should Maggy contribute to her 401(k) account? a. At the time Maggy leaves YBU, she has contributed $14,560 [($45,000 + $52,000 + $55,000 + 50% (half year) × $60,000) × 8%)]. Maggy automatically vests in her own contributions (and the earnings on those contributions) no matter how long she works for YBU. Because YBU contributes 50 cents for every dollar contributed by the employee, YBU contributes $7,280 to Maggy’s plan ($14,560 × .5). Because YBU uses 3-year cliff vesting, and Maggy has worked for YBU for more than three years, Maggy is fully vested in YBU’s contributions (and the earnings on those contributions). Since Maggy is fully vested in all of the contributions to her 401(k) account, she is fully vested in the entire balance in her 401(k) account ($21,840 [$14,560 + $7,280] + earnings on the account) when she leaves YBU. b. At the time Maggy leaves YBU, she has contributed $14,560 [($45,000 + $52,000 + $55,000 + 50% (half year) × $60,000) × 8%)]. Maggy automatically vests in her own contributions no matter how long she works for YBU. Because YBU contributes 50 cents for every dollar contributed by the employee, YBU contributes $7,280 to Maggy’s plan ($14,560 × .5). Assuming YBU uses six-year graded vesting and Maggy has worked for YBU for three full years, Maggy’s vesting percentage in YBU’s contributions is 40%. Thus, Maggy’s vested benefit in YBU contributions is $2,912 ($7,280 × 40%) and her vested benefit in the earnings on YBU’s contributions is also 40%. To summarize, Maggy is fully vested in her $14,560 contributions and on the earnings on those contributions. She is also vested in $2,912 of YBU’s contributions and she is vested in 40% of the earnings on those contributions. In total, she is vested in $17,472 of the $21,840 contributed to her 401(k) account, excluding account earnings. c. YBU contributes 50 cents per dollar contributed by an employee to her 401(k) plan up to 15% of an employee’s salary (if allowed, YBU contributes until an employee contributes 30% of her salary). However, for 2020, employees are limited to contributing $19,500 to defined contribution plans. In this instance Maggy should contribute the entire $19,500 and receive a contribution from her employer of $9,750 ($19,500 × 50%) for a total contribution to her 401(k) of $29,250. d. Just as in explanation (c), to maximize the contributions to her 401(k) account, Maggy should contribute a total of $26,000 ($19,500 plus the $6,500 catch up adjustment for taxpayers age 50 years and older at the end of the year). YBU would contribute an additional $13,000 to her account ($26,000 × .5). For the year, 39,000 ($26,000 + $13,000) would be contributed to her account. 56. [LO 2] In 2020, Nina contributes 10 percent of her $100,000 annual salary to her 401(k) account. She expects to earn a 7 percent before-tax rate of return. Assuming she leaves this (and any employer contributions) in the account until she retires in 25 years, what is Nina’s after-tax accumulation from her 2020 contributions to her 401(k) account? a. Assume Nina’s marginal tax rate at retirement is 30 percent. b. Assume Nina’s marginal tax rate at retirement 20 percent. c. Assume Nina’s marginal tax rate at retirement is 40 percent. a. $37,992, computed as follows: Before-tax contribution $10,000 Times future value factor × 1.0725 7% annual rate for 25 years Future value of contribution $54,274 Minus: taxes payables on distribution (16,282) (54,274 × 30% tax rate) After tax proceeds from distribution $37,992 Value of account minus taxes payable b. $43,419 Before-tax contribution $10,000 Times future value factor × 1.0725 7% annual rate of return for 25 years Future value of contribution $54,274 Minus: taxes payables on distribution (10,855) (54,274 × 20% tax rate) After tax proceeds from distribution $43,419 Value of account minus taxes payable c. $32,564. Before-tax contribution $10,000 Times future value factor × 1.0725 7% annual rate of return for 25 years Future value of contribution $54,274 Minus: taxes payables on distribution (21,710) (54,274 × 40% tax rate) After tax proceeds from distribution $32,564 Value of account minus taxes payable 57. [LO 2] Kathleen, age 56, works for MH Inc. in Dallas, TX. Kathleen contributes to a Roth 401(k), and MH contributes to a traditional 401(k) on her behalf. Kathleen has contributed $30,000 to her Roth 401(k) over the past six years. The current balance in her Roth 401(k) account is $50,000 and the balance in her traditional 401(k) is $40,000. Kathleen needs cash because she is taking a month of vacation to travel the world. Answer the following questions relating to distributions from Kathleen’s retirement accounts assuming her marginal tax rate for ordinary income is 24 percent. a. If Kathleen receives a $10,000 distribution from her traditional 401(k) account, how much will she be able to keep after paying taxes and penalties, if any, on the distribution? b. If Kathleen receives a $10,000 distribution from her Roth 401(k) account, how much will she be able to keep after paying taxes and penalties, if any, on the distribution? c. If Kathleen retires from MH and then she receives a $10,000 distribution from her traditional 401(k), how much will she be able to keep after paying taxes and penalties, if any, on the distribution? d. If Kathleen retires from MH and then she receives a $10,000 distribution from her Roth 401(k), how much will she be able to keep after paying taxes and penalties, if any, on the distribution? e. Assume the original facts except that Kathleen is 60 years of age, not 56. If Kathleen receives a $10,000 distribution from her Roth 401(k) (without retiring), how much will she be able to keep after paying taxes and penalties, if any, on the distribution? a. $6,600. Kathleen will be required to pay $2,400 in federal income taxes ($10,000 × 24%) and $1,000 in early distribution penalties ($10,000 × 10%) because she has not retired and she is not at least 59 ½ years of age at the time of the distribution. Consequently, she will keep $6,600 ($10,000 – 2,400 – 1,000) of the $10,000 distribution. b. $8,640. Because this is not a qualified distribution (Kathleen is not 59 ½ and has not retired) a portion of it is taxable and subject to the 10% early distribution penalty. The amount of the distribution treated as a distribution of her own contributions (and thus not taxable or penalized) is $30,000 (her contributions) / $50,000 account balance. Thus 60% of the distribution is nontaxable and $4,000 is taxable and penalized. Kathleen will pay $960 in taxes ($4,000 × 24%) + $400 in penalties ($4,000 × 10%). Consequently, she will be able to keep $8,640 ($10,000 – 960 – 400) of the distribution to fund her travels. c. $7,600. Because Kathleen is older than 55 and she has retired from MH, she is not penalized on the distribution. She must still pay $2,400 in income tax on the $10,000 distribution, leaving her with $7,600. d. $9,040. Because this is not a qualified distribution (she is not 59 ½ years of age at the time she received the distribution), a portion of it is taxable. However, because she is at least age 55 years of age and has retired, she is not subject to the 10 percent penalty. The amount of the distribution treated as a distribution of her own contributions (and thus not taxable or penalized) is $30,000 (her contributions) / $50,000 account balance. Thus 60% of the distribution is nontaxable and $4,000 is taxable. Kathleen will pay $960 in taxes ($4,000 × 24%). Consequently, she will be able to keep $9,040 ($10,000 – 960) of the distribution to fund her travels. e. $10,000. She gets to keep it all because this is a qualified distribution (older than 59 ½ and she has had the account open for more than five years). She does not pay a penalty and she is not taxed on the distribution because it is a Roth account. It does not matter that she has not retired. 58. [LO 2] In 2020, Nitai (age 40) contributes 10 percent of his $100,000 annual salary to a Roth 401(k) account sponsored by his employer, AY Inc. AY Inc. matches employee contributions to the employee’s traditional 401(k) account dollar-for-dollar up to 10 percent of the employee’s salary. Nitai expects to earn a 7 percent before-tax rate of return. Assume he leaves the contributions in the Roth 401(k) and traditional 401(k) accounts until he retires in 25 years and that he makes no additional contributions to either account. What are Nitai’s after-tax proceeds from the Roth 401(k) and traditional 401(k) accounts after he receives the distributions, assuming his marginal tax rate at retirement is 30 percent? Because distributions from a Roth 401(k) are not taxable, Nitai’s accumulation on his 2020 contribution to his Roth 401(k) plan is $54,274. Roth 401(k): $10,000 × 1.0725 = $54,274. His marginal tax rate when he retires does not affect the after-tax proceeds of the distribution because distributions at retirement from Roth 401(k) plans are not taxable. (Note that Nitai was not able to deduct his Roth 401(k) contribution.) Traditional 401(k) Nitai did not contribute to his traditional 401(k) plan during 2020. However, his employer, AY Inc., contributed one dollar for every dollar that Nitai contributed to his Roth 401(k) account. Consequently, AY Inc. contributed $10,000 to his traditional 401(k) account. Because distributions from a traditional 401(k) account are fully taxable to the recipient as ordinary income in the year of distribution and Nitai’s marginal rate at that time is 30%, Nitai’s after-tax accumulation from his traditional 401(k) plan is as follows: $10,000 × 1.0725 × (1 – 30%) = $37,992 59. [LO 3] {Planning} Marissa participates in her employer’s nonqualified deferred compensation plan. For 2020, she is deferring 10 percent of her $320,000 annual salary. Assuming this is her only source of income and her marginal income tax rate is 32 percent, how much tax does Marissa save in 2020 by deferring this income (ignore payroll taxes)? $10,240. Because Marissa is not required to pay tax on the $32,000 deferred salary ($320,000 × 10%), she will save $10,240 ($32,000 × 32% marginal tax rate) in taxes. 60. [LO 3] Paris participates in her employer’s nonqualified deferred compensation plan. For 2020, she is deferring 10 percent of her $320,000 annual salary. Assuming this is her only source of income and her marginal income tax rate is 32 percent, how much does deferring Paris’ income save her employer (after taxes) in 2020? The marginal tax rate of her employer is 21 percent (ignore payroll taxes). $25,280. 10% of Paris’s compensation is $32,000. By not paying this to Paris currently, Paris’s employer saves $25,280 [$32,000 × (1 – .21)] which is its after-tax cost of her salary. 61. [LO 3] {Planning} Leslie participates in IBO’s nonqualified deferred compensation plan. For 2020, she is deferring 10 percent of her $300,000 annual salary. Based on her deemed investment choice, Leslie expects to earn a 7 percent before-tax rate of return on her deferred compensation, which she plans to receive in 10 years. Leslie’s marginal tax rate in 2020 is 32 percent. IBO’s marginal tax rate is 21 percent (ignore payroll taxes in your analysis). a. Assuming Leslie’s marginal tax rate in 10 years (when she receives the distribution) is 33 percent, what is Leslie’s after-tax accumulation on the deferred compensation? b. Assuming Leslie’s marginal tax rate in 10 years (when she receives the distribution) is 20 percent, what is Leslie’s after-tax accumulation on the deferred compensation? c. Assuming IBO’s cost of capital is 8 percent after taxes, how much deferred compensation should IBO be willing to pay Leslie that would make it indifferent between paying 10 percent of Leslie’s current salary or deferring it for 10 years? a. Leslie’s after-tax accumulation is as follows: $30,000 × (1.07)10 × (1 - .33) = $39,540 Her initial contribution of $30,000 grows at 7% for 10 years and then is all taxed at 33% when she receives it. b. Leslie’s after-tax accumulation is as follows: $30,000 × (1.07)10 × (1 - .2) =$47,212 Her initial contribution of $30,000 grows at 7% for 10 years and then is all taxed at 20% when she receives it. c. $64,768. IBO’s after-tax cost of providing Leslie with $30,000 of current compensation is $23,700 [$30,000 × (1 – .21)]. IBO should be indifferent between paying her current salary at an after-tax cost of $23,700 and paying her in 10 years the amount (after-taxes) that this would grow to if IBO were to invest this amount and earn 8% after-taxes. In 10 years the $23,700 would grow to $51,167 [$23,700 × (1.08)10]. IBO should be indifferent between paying current salary and paying some amount of deferred compensation (DC) that would cost it $51,167 after taxes in 10 years. To determine the amount of deferred compensation we need to solve for DC in the following equation: $51,167 = DC × (1 –.21) DC = $64,768. 62. [LO 3] {Planning} XYZ Corporation has a deferred compensation plan under which it allows certain employees to defer up to 40 percent of their salary for five years. For purposes of this problem, ignore payroll taxes in your computations. a. Assume XYZ has a marginal tax rate of 21 percent for the foreseeable future and earns an after-tax rate of return of 8 percent on its assets. Joel Johnson, XYZ’s VP of finance, is attempting to determine what amount of deferred compensation XYZ should be willing to pay in five years that would make XYZ indifferent between paying current salary of $10,000 and paying the deferred compensation. What amount of deferred compensation would accomplish this objective? b. Assume Julie, an XYZ employee, has the option of participating in XYZ’s deferred compensation plan. Julie’s marginal tax rate is 37 percent, and she expects the rate to remain constant over the next five years. Julie is trying to decide how much deferred compensation she will need to receive from XYZ in five years to make her indifferent between receiving the current salary of $10,000 and receiving the deferred compensation payment. If Julie takes the salary, she will invest it in a taxable corporate bond paying interest at 5 percent annually (after taxes). What amount of deferred compensation would accomplish this objective? a. $14,694. If XYZ were to pay $10,000, its after-tax cost would be $7,900 [$10,000 × (1 –.21)]. If it defers the compensation it would save $7,900 after-taxes. This is equivalent to $11,608 after-taxes in 5 years ($7,900 × 1.085). So, XYZ should be indifferent between paying Joel $7,900 after-taxes now or $11,608 after taxes in 5 years. Assuming XYZ’s marginal tax rate remains at 21%, $11,608 after-taxes is $14,694 before-taxes [$11,608/(1 –.21)]. b. $12,763. If Julie were to take the salary now, she would receive $6,300 after tax (10,000 × (1 – .37)). She would then invest this amount in taxable corporate bonds. After five years Julie would have accumulated $8,041 after taxes by taking the salary and investing it herself [(6,300 × 1.055]. Thus, in order to be indifferent after five years between the salary and deferred compensation, she must receive enough deferred compensation to provide her with $8,041 after she pays tax at her 37% marginal tax rate. If she receives $12,763, she will have $8,041 after taxes [$12,763 × (1-.37)]. 63. [LO 4] John (age 51 and single) has earned income of $3,000. He has $30,000 of unearned (capital gain) income. a. If he does not participate in an employer-sponsored plan, what is the maximum deductible IRA contribution John can make in 2020? b. If he does participate in an employer-sponsored plan, what is the maximum deductible IRA contribution John can make in 2020? c. If he does not participate in an employer-sponsored plan, what is the maximum deductible IRA contribution John can make in 2020 if he has earned income of $10,000? a. $3,000. Deductible contributions to an IRA account are limited to the lesser of $6,000 or earned income. If the individual is at least 50 years old by the end of the year, he/she may make a contribution of up to the lesser of $7,000 or earned income. In this case, John’s deductible contribution is the lesser of (1) his earned income of $3,000 or (2) the maximum deductible amount of $7,000. So, his deductible contribution is $3,000. b. $3,000. Taxpayers who are participants in an employer-sponsored retirement plan are allowed to make deductible contributions to an IRA account as long as they meet certain modified AGI (MAGI) restrictions. In 2020, the deductibility of IRA contributions is phased-out proportionally for MAGI between $65,000 and $75,000. John’s MAGI of $33,000 (3,000 earned income + 30,000 capital gain) falls below the $65,000 MAGI phase-out threshold. Thus, John is allowed to make a contribution equal to the lesser of $7,000 or earned income (The $7,000 = $6,000 standard contribution limit + $1,000 catch-up contribution for taxpayers age 50 and over). So, he is allowed to deduct $3,000. c. $7,000. Deductible contributions are limited to the lesser of $6,000 or earned income. The $6,000 limit is increased to $7,000 for taxpayers who have reached the age of 50 by the end of the year (taxpayers age 50 or older at the end of the year are allowed to make an additional $1,000 catch-up contribution). Thus, John may make a total deductible contribution equal to the lesser of $7,000 (6,000 + 1,000) or earned income ($10,000). So, he is allowed to deduct $7,000. 64. [LO 4] William is a single writer (age 35) who recently decided that he needs to save more for retirement. His 2020 AGI before the IRA contribution deduction is $66,000 (all earned income). a. If he does not participate in an employer-sponsored plan, what is the maximum deductible IRA contribution William can make in 2020? b. If he does participate in an employer-sponsored plan, what is the maximum deductible IRA contribution William can make in 2020? c. Assuming the same facts as in part (b), except William’s AGI before the IRA contribution deduction is $76,000. What is the maximum deductible IRA contribution William can make in 2020? a. $6,000. Because William is not covered by an employer provided retirement plan, his deductible contribution is not limited by AGI. Also, because he is under 50 years of age at the end of the year, his maximum deductible IRA contribution for the year is $6,000. b. $5,400. Because William is under 50 years of age at the end of the year, his maximum deductible contribution (before phase-out) is $6,000. However, because he is covered by an employer sponsored plan as a single taxpayer, William’s maximum deductible contribution is phased out proportionally for MAGI between $65,000 and $75,000. William’s MAGI of $66,000 is 10% of the way through the $10,000 phase-out range [($66,000 – $65,000)/($75,000 – $65,000)] so he is not allowed to deduct 10% of the $6,000 maximum deductible contribution. But he is allowed to deduct 90% of his maximum deductible contribution of $6,000 which is $5,400. c. The maximum deductible IRA contribution that William can contribute in 2020 is $0. Because he is covered by an employer-provided plan, the maximum deductible contribution for unmarried taxpayers phases out between MAGI of $65,000 and $75,000 and William’s MAGI exceeds $75,000. Consequently, he cannot make a deductible IRA contribution. 65. [LO 4] In 2020, Susan (44 years old) is a highly successful architect and is covered by an employee-sponsored plan. Her husband, Dan (47 years old), however, is a Ph.D. student and is unemployed. Compute the maximum deductible IRA contribution for each spouse in the following alternative situations. a. Susan’s salary and the couple’s AGI before any IRA contribution deductions is $199,000. The couple files a joint tax return. b. Susan’s salary and the couple’s AGI before any IRA contribution deductions is $129,000. The couple files a joint tax return. c. Susan’s salary and the couple’s AGI before any IRA contribution deductions is $83,000. The couple files a joint tax return. d. Susan’s salary and her AGI before the IRA contribution deduction is $83,000. Dan reports $5,000 of AGI before the IRA contribution deduction (earned income). The couple files separate tax returns. a. Susan’s maximum deductible contribution is $0. Dan’s maximum deductible contribution is $4,200. Susan’s maximum deductible contribution is $0 because she is an active participant in an employer’s retirement plan and the MAGI on the couple’s joint return exceeds $124,000, so her deductible contribution is entirely phased out. Dan’s maximum deductible contribution of $6,000 is partially phased-out because Dan and Susan’s MAGI is in the proportional phase-out range. The phase-out percentage is calculated as follows: ($199,000 – $196,000)/($206,000 – $196,000) = 30%. The 30% is then multiplied by $6,000 to provide the phase-out amount of $1,800. Thus, Dan’s maximum deductible contribution is $4,200 ($6,000 minus $1,800). b. Susan’s maximum deductible contribution is $0. Because she is an active participant in an employer’s plan and the couple’s MAGI exceeds $124,000, her deductible contribution is entirely phased out. Dan’s maximum deductible contribution is $6,000. This is the lesser of (1) $6,000 or (2) the couple’s earned income of $129,000 (reduced by nondeductible IRA contributions or Roth IRA contributions by Susan—here we assume none). Dan is able to contribute $6,000 even though he doesn’t have any earned income because the couple has earned income and the couple’s MAGI is less than $196,000. c. Susan’s maximum deductible contribution is $6,000 and Dan’s maximum deductible contribution is $6,000. Even though Susan is an active participant in an employer’s retirement plan she is able to make a deductible contribution because the couple’s MAGI is less than $104,000. Dan is able to make a $6,000 deductible contribution which is the lesser of (1) $6,000 or (2) $77,000 ($83,000 minus $6,000) which is the couple’s MAGI minus Susan’s deductible contribution. d. Susan’s maximum deductible contribution is $0 because she is filing separately and her MAGI exceeds $10,000. Dan is able to make a $3,000 deductible contribution. His maximum deductible contribution before phase out is $6,000. Because he is filing a separate return, his maximum contribution phases out proportionally between $0 and $10,000 of MAGI. Here his $5,000 MAGI is 50% of the way through the phase out range so he loses 50% of his otherwise deductible contribution. 66. [LO 4] {Tax Forms} In 2020, Rashaun (62 years old) retired and planned on immediately receiving distributions (making withdrawals) from his traditional IRA account. The balance of his IRA account is $160,000 (before reducing it for withdrawals/distributions described below). Over the years, Rashaun has contributed $40,000 to the IRA. Of his $40,000 contributions, $30,000 was nondeductible and $10,000 was deductible. Assume Rashaun did not make any contributions to the account in 2020. a. If Rashaun currently withdraws $20,000 from the IRA, how much tax will he be required to pay on the withdrawal if his marginal tax rate is 24 percent? b. If Rashaun currently withdraws $70,000 from the IRA, how much tax will he be required to pay on the withdrawal if his marginal tax rate is 28 percent? c. {Forms} Using the information provided in part (b), complete Form 8606, Part I, to report the taxable portion of the $70,000 distribution (withdrawal). Use the most current form available. a. $3,900. Because Rashaun has made both deductible and nondeductible contributions to his IRA, he needs to allocate the distribution between taxable amounts and amounts that are a return of his nondeductible contribution. To do this, he first has to determine the ratio of nondeductible contributions to the value of the IRA at the time of the distribution. In this case the ratio is $30,000/$160,000 or 18.75%. Consequently, $3,750 (20,000 × 18.75%) is not taxable and the remaining $16,250 is taxed at Rashaun’s marginal tax rate of 24%. Thus, Rashaun must pay $3,900 in taxes ($16,250 × 24%) and the overall amount he receives after taxes is $16,100 [3,750 + (16,250 × (1 – .24)]. b. $15,925. Again, because Rashaun has made both deductible and nondeductible contributions, he needs to allocate the distribution between taxable amounts and amounts that are a return of his nondeductible contributions. His ratio of nondeductible contributions to the value of the IRA is 30,000/160,000 or 18.75%. Consequently, $13,125 (70,000 × 18.75%) is not taxable and the remaining $56,875 (70,000 – 13,125) is taxed at his marginal tax rate of 28% for taxes of $15,925 ($56,875 × 28%). After taxes, Rashaun receives $54,075 [13,125 + (56,875 – 15,925)]. c. See below 67. [LO 4] Brooklyn has been contributing to a traditional IRA for seven years (all deductible contributions) and has a total of $30,000 in the account. In 2020, she is 39 years old and has decided that she wants to get a new car. She withdraws $20,000 from the IRA to help pay for the car. She is currently in the 24 percent marginal tax bracket. What amount of the withdrawal, after tax considerations, will Brooklyn have available to purchase the car? Brooklyn will be taxed at 24% on the $20,000 withdrawal. Consequently, she will pay $4,800 in taxes (20,000 × 24%). In addition, she must pay a 10% early distribution penalty on the $20,000 withdrawal ($20,000 × 10% = $2,000 penalty). This leaves her with $13,200 after taxes ($20,000 – 4,800 taxes – 2,000 penalties) to purchase the car. 68. [LO 4] Jackson and Ashley Turner (both 45 years old) are married and want to contribute to a Roth IRA for Ashley. In 2020, their AGI is $201,000. Jackson and Ashley each earned half of the income. a. How much can Ashley contribute to her Roth IRA if they file a joint return? b. How much can Ashley contribute if she files a separate return? c. Assume that Ashley earned all of the couple’s income and that she contributed the maximum amount she is allowed to contribute to a Roth IRA. What amount can be contributed to Jackson’s Roth IRA? a. $3,000. Individuals are allowed to contribute to a Roth IRA as long as their AGI falls below certain threshold limits. The AGI threshold limits for married individuals filing jointly is between $196,000 and $206,000. Because Jackson and Ashley’s AGI is 50% of the way between $196,000 and $206,000 [($201,000 – 196,000)/($206,000 – 196,000)], Ashley’s maximum contribution is phased out by 50%. That is, of the $6,000 maximum contribution, Ashley may contribute $3,000 [$6,000 × 50% (100% – 50% phased-out percentage)]. b. $0. The AGI threshold limits for married individuals filing separately is between $0 and $10,000. Thus, if they filed separately, Ashley would not be able to contribute to a Roth IRA. c. $3,000. Because Jackson is the lesser earning spouse, the starting point for determining the amount he can contribute is the lesser of $6,000 or $198,000 [total earned income of both spouses of $201,000 reduced by the $3,000 contribution to Ashley’s account (see answer to part a)]. However, because the couple’s AGI of $201,000 exceeds $196,000, 50% of Jackson’s contribution limit is phased out [($201,000 – 196,000)/($206,000 – 196,000)]. That is, of the $6,000 maximum contribution, only $3,000 [$6,000 × 50% (100% – 50% phased-out percentage)] may be contributed to Jackson’s Roth IRA. 69. [LO 4] Harriet and Harry Combs (both 37 years old) are married and both want to contribute to a Roth IRA. In 2020, their AGI before any IRA contribution deductions is $50,000. Harriet earned $46,000 and Harry earned $4,000. a. How much can Harriet contribute to her Roth IRA if they file a joint return? b. How much can Harriet contribute if she files a separate return? c. How much can Harry contribute to his Roth IRA if they file separately? a. $6,000. Individuals are allowed to contribute to a Roth IRA as long as their MAGI falls below certain phase-out threshold limits. For married individuals filing jointly, the ability to contribute starts to phase out once MAGI hits $196,000 and is fully phased out when MAGI reaches $206,000. Because Harriet and Harry’s MAGI is below $196,000, Harriet can contribute $6,000, the maximum contribution for taxpayers under age 50 at the end of the year. b. $0 The MAGI based phase-out range for married individuals filing separately is between $0 and $10,000. Thus, if Harriet files separately, she would not be allowed to contribute to Roth IRA because her MAGI is $46,000. c. $3,600 ($6,000 × 60%). Since Harry’s MAGI is 40% of the way between $0 and $10,000 [($4,000 – 0)/(10,000 – 0)], Harry is only allowed to contribute 60% (100% – 40% disallowed percentage) of the $6,000 maximum contribution for tax payers under 50 years of age at year end. 70. [LO 4] Michael is single and 35 years old. He is a participant in his employer’s sponsored retirement plan. How much can Michael contribute to a Roth IRA in 2020 in each of the following alternative situations? a. Michael’s AGI before the IRA contribution deduction is $50,000. Michael contributed $3,000 to a traditional IRA. b. Michael’s AGI is $80,000 before any IRA contributions. c. Michael’s AGI is $155,000 before any IRA contributions. a. $3,000. Michael has contributed $3,000 to a traditional IRA. Because his MAGI was below the phase-out threshold ($65,000), he was able to deduct all $3,000 of that contribution. Because a taxpayer’s contributions to traditional and Roth IRAs may not exceed $6,000 (taxpayers under 50 years of age) and because his MAGI is below the Roth IRA phase-out threshold ($124,000), he may contribute $3,000 to the Roth ($6,000 total minus $3,000 contribution to traditional IRA). b. $6,000. Michael’s MAGI is too high to contribute to a deductible IRA but he is below the phase-out threshold ($124,000) for contributing to a Roth IRA so he could contribute $6,000 to a Roth IRA. c. $0. Michael’s MAGI is too high to contribute to a Roth IRA. It is also too high (AGI is greater than $139,000) to contribute to a deductible IRA. In this case, Michael’s only option for contributing to an IRA is that he can contribute $6,000 to a nondeductible IRA. 71. [LO 4] George (age 42 at year-end) has been contributing to a traditional IRA for years (all deductible contributions), and his IRA is now worth $25,000. He is planning on converting the entire balance to a Roth IRA account. George’s marginal tax rate is 24 percent. a. What are the tax consequences to George if he takes $25,000 out of the traditional IRA and contributes the entire amount into a Roth IRA one week after receiving the distribution? b. What are the tax consequences to George if he takes $25,000 out of the traditional IRA, pays the taxes due from the traditional IRA distribution, and contributes the what’s left from the distribution to the Roth IRA one week after receiving the distribution? c. What are the tax consequences to George if he takes $25,000 out of the traditional IRA, keeps $10,000 to pay taxes and to make a down payment on a new car, and contributes the what’s left from the distribution to the Roth IRA one week after receiving the distribution? a. George will have to pay taxes of $6,000 (24% × 25,000) for taking the $25,000 out of the IRA. However, he will not have to pay the 10% penalty tax because he deposited the entire $25,000 (the entire amount of the withdrawal) into a Roth IRA within 60 days of taking it out of the traditional IRA. b. George will have to pay taxes of $6,000 for taking the $25,000 out of the IRA. After taxes, this leaves $19,000 ($25,000 – 6,000) for George to contribute to the Roth IRA. However, because he doesn’t contribute (rollover) $25,000 (the full amount that was withdrawn from the traditional IRA), he will also have to pay the 10% penalty tax on the $6,000 that he did not contribute or roll over. Therefore, he will have to pay a penalty of $600 ($6,000 × 10%). In total he will pay taxes of $6,600 ($6,000 income tax + 600 penalty tax) on the transaction. c. George will have to pay taxes of $6,000 for taking the $25,000 out of the IRA. After taxes, this leaves him with $19,000 ($25,000 – 6,000). Because George only contributes $15,000 to the Roth IRA, he must pay a 10% penalty tax on the $10,000 that he took out of the traditional IRA and did not contribute or roll over to a Roth IRA. Consequently, he pays a $1,000 penalty ($10,000 × 10%). In total, George must pay $7,000 ($1,000 penalty + $6,000 tax) in taxes on the distribution. 72. [LO 4] Jimmer has contributed $15,000 to his Roth IRA, and the balance in the account is $18,000. In the current year, Jimmer withdrew $17,000 from the Roth IRA to pay for a new car. If Jimmer’s marginal ordinary income tax rate is 24 percent, what amount of tax and penalty, if any, is Jimmer required to pay on the withdrawal in each of the following alternative situations? a. Jimmer opened the Roth account 44 months before he withdrew the $17,000, and Jimmer is 62 years of age. b. Jimmer opened the Roth account 44 months before he withdrew the $17,000, and Jimmer is age 53. c. Jimmer opened the Roth account 76 months before he withdrew the $17,000, and Jimmer is age 62. d. Jimmer opened the Roth account 76 months before he withdrew the $17,000, and Jimmer is age 53. a. $480 tax and $0 penalty. Because the Roth account has not been open for five years at the time of the distribution, this is a nonqualified distribution. Because Jimmer contributed $15,000, he is allowed to receive $15,000 in distributions from the account without paying tax or penalty. However, because it is a nonqualified distribution, he must pay tax of $480 ($2,000 × 24%) on the $2,000 of earnings distributed ($17,000 minus $15,000). But, because he is at least 59 ½ years of age at the time of the distribution, the distribution of earnings is not subject to the 10% penalty. b. $480 tax and $200 penalty. Because the Roth account has not been open for five years (and Jimmer has not reached age 59 ½ by the time of the distribution), this is a nonqualified distribution. Because Jimmer contributed $15,000, he is allowed to receive $15,000 in distributions from the account without paying tax or penalty. However, because it is a nonqualified distribution, he must pay tax of $480 ($2,000 × 24%) on the distribution. Further, because he is not 59 ½ years of age at the time of the distribution, he must pay a $200 penalty ($2,000 × 10%) on the $2,000 earnings that Jimmer received in the distribution. c. $0 tax and $0 penalty. Because this is a qualified distribution (distribution is after Jimmer has attained 59 ½ years of age and the Roth account has been open for more than five years) the distribution is not subject to tax or penalty. d. $480 tax and $200 penalty. Because Jimmer has not reached age 59 ½ by the time of the distribution, this is a nonqualified distribution. Because Jimmer contributed $15,000, he is allowed to receive $15,000 in distributions from the account without paying tax or penalty. However, because it is a nonqualified distribution, he must pay tax of $480 ($2,000 × 24%) on the distribution. Further, because he is not 59 ½ years of age at the time of the distribution, he must pay a penalty of $200 ($2,000 × 10%) on the $2,000 earnings that Jimmer received in the distribution. 73. [LO 4] {Planning} John is trying to decide whether to contribute to a Roth IRA or traditional IRA. He plans on making a $5,000 contribution to whichever plan he decides to fund. He currently pays tax at a 32 percent marginal income tax rate, but he believes that his marginal tax rate in the future will be 28 percent. He intends to leave the money in the Roth IRA or traditional IRA accounts for 30 years, and he expects to earn a 6 percent before-tax rate of return on the account. a. How much will John accumulate after taxes if he contributes to a Roth IRA (consider only the funds contributed to the Roth IRA)? b. How much will John accumulate after taxes if he contributes to a traditional IRA (consider only the funds contributed to the traditional IRA)? c. Without doing any computations, explain whether the traditional IRA or the Roth IRA will generate a greater after-tax rate of return. a. $28,717, calculated as follows: $5,000 × (1.06)30 = $28,717. John’s contribution grows tax free at 6% per year for 30 years and it is not taxed on withdrawal. b. $20,677, calculated as follows: $5,000 × (1.06)30 × (1 – 28%) = $20,677. John’s contribution grows tax free at 6% for 30 years. However, because his initial contribution was deductible [this saved him $1,600 in taxes ($5,000 × 32% MTR)] the entire distribution is taxable. Because his marginal tax rate was 28% when he received the distribution, he must pay 28% of the total distribution in taxes. c. The traditional IRA. The rate of return on the Roth IRA is the 6% before tax rate of return (the contribution is not deductible and the distribution is not taxable so no effect of taxes). However, the rate of return on the traditional IRA exceeds 6% because the contribution was deductible and saved taxes at 32%; the distribution was fully taxable but it only cost taxes at 28% (higher tax rate for deduction than for income generates higher than before tax rate of return). Note that the traditional IRA provides a lower accumulation than the Roth because the initial contribution of “after-tax” dollars was less for the traditional IRA. That is, the after-tax contribution to the Roth was $5,000 but the after-tax contribution to the traditional IRA was $3,400 ($5,000 contribution minus $1,600 tax savings from deduction). 74. [LO 4] Sherry, who is 52 years of age, opened a Roth IRA three years ago. She has contributed a total of $12,000 to a Roth IRA ($4,000 a year). The current value of the Roth IRA is $16,300. In the current year, Sherry withdraws $14,000 of the account balance to purchase a car. Assuming Sherry’s marginal tax rate is 24 percent, how much of the $14,000 withdrawal will she retain after taxes to fund her car purchase? Because Sherry has made a withdrawal from her Roth IRA within five years of opening it, she has received a nonqualified distribution. Nonqualified distributions are non-taxable to the extent they are attributable to contributions; the earnings made on such contributions are taxed as ordinary income. Further, because she is not 59 ½ years of age at the time of the distribution, the distribution of earnings is also subject to a 10% penalty. In this instance, Sherry has withdrawn $2,000 of earnings (14,000 withdrawal – 12,000 contributions) and will pay taxes of $480 (24% × 2,000) and a penalty of $200 (10% × 2,000). Of the $14,000 withdrawn, Sherry will retain after-taxes $13,320 ($14,000 withdrawal – 480 taxes – 200 penalty). 75. [LO 4] Seven years ago, Halle (currently age 41) contributed $4,000 to a Roth IRA account. The current value of the Roth IRA is $9,000. In the current, year Halle withdraws $8,000 of the account balance to use as a down payment on her first home. Assuming Halle’s marginal tax rate is 24, how much of the $8,000 withdrawal will she retain after taxes to fund her house down payment? All $8,000. Because Halle has had her Roth IRA open for at least five years and she used the distribution proceeds as a down payment (not to exceed $10,000) on her first home, the entire distribution is considered a qualified distribution and is not taxable and is not penalized. 76. [LO4] {Planning} {Research} Yuki (age 45 at year-end) has been contributing to a traditional IRA for years (all deductible contributions), and her IRA is now worth $50,000. She is trying to decide whether she should convert her traditional IRA into a Roth IRA. Her current marginal tax rate is 24 percent. She plans to withdraw the entire balance of the account in 20 years, and she expects to earn a before-tax rate of return of 5 percent on her retirement accounts and a 4 percent after-tax rate of return on all investments outside of her retirement accounts. For each of the following alternative scenarios, indicate how much more or less Yuki will accumulate after taxes in 20 years if she converts her traditional IRA into a Roth IRA. Be sure to include the opportunity cost of having to pay taxes on the conversion. a. When she withdraws the retirement funds in 20 years, she expects her marginal tax rate to be 35%. $20,140 greater accumulation if she converts her traditional IRA into Roth IRA. See calculations below: • Accumulation if she keeps funds in traditional IRA: ○ $86,232 [$50,000 × 1.0520 × (1 - .35)] • Accumulation if she converts traditional IRA into Roth IRA: $106,372 ○ $50,000 × 1.0520 = $132,665 total accumulation (before considering opportunity cost of tax cost of converting) ○ $12,000 × 1.0420 = $26,293 opportunity cost for having to pay tax on rollover (by converting traditional IRA), Yuki will have to pay $12,000 in taxes ($50,000 × 24%). Because she pays $12,000 in taxes with funds that are outside her retirement accounts, she will miss the opportunity of generating a 4% after-tax rate of return on the $12,000 for 20 years. ○ Accumulation of Roth IRA net of opportunity cost associated with taxes paid on conversion = $106,372 ($132,665 – $26,293). • Roth IRA accumulation $106,372 minus traditional IRA accumulation $86,232 = $20,140 greater accumulation if she converts traditional into Roth IRA. b. When she withdraws the retirement funds in 20 years, she expects her marginal tax rate to be 18 percent. $2,413 lower accumulation if she contributes traditional IRA into Roth IRA (greater accumulation if she does not rollover). See calculations below: • Accumulation if she keeps funds in traditional IRA: ○ $108,785 [$50,000 × 1.0520 × (1 - .18)] • Accumulation if she converts traditional IRA into Roth IRA: $106,372 ○ $50,000 × 1.0520 = $132,665 total accumulation (before considering opportunity cost of tax cost of rolling over) ○ $12,000 × 1.0420 = $26,293 opportunity cost for having to pay tax on rollover (by converting traditional IRA), Yuki will have to pay $12,000 in taxes ($50,000 × 24%). Because she pays $12,000 in taxes with funds outside her retirement account, she will miss the opportunity of generating a 4% after-tax rate of return on the $12,000 for 20 years. ○ Accumulation of Roth IRA net of opportunity cost associated with taxes paid on conversion = $106,372 ($132,665 – $26,293). • Roth IRA accumulation $106,372 minus traditional IRA accumulation $108,785 = ($2,413) smaller accumulation if she rolls over traditional into Roth IRA. That is, she will accumulate $2,413 more if she does not convert the traditional IRA into a Roth IRA. c. Assume the same facts as in part (b), except that she earns a 3 percent after-tax rate of return on investments outside of the retirement accounts? $2,207 greater accumulation if she converts her traditional IRA into Roth IRA. See calculations below: • Accumulation if she keeps funds in traditional IRA: ○ $108,785 [$50,000 × 1.0520 × (1 - .18)] • Accumulation if she converts into Roth IRA: $110,092 ○ $50,000 × 1.0520 = $132,665 total accumulation (before considering opportunity cost of tax cost of converting) ○ $12,000 × 1.0320 = $21,673 opportunity cost for having to pay tax on rollover (by converting traditional IRA), Yuki will have to pay $12,000 in taxes ($50,000 × 24%). Because she pays $12,000 in taxes with funds outside her retirement account, she will miss the opportunity of generating a 2% after-tax rate of return on the $12,000 for 20 years. ○ Accumulation of Roth IRA net of opportunity cost associated with taxes paid on conversion = $110,992 ($132,665 – $21,673). • Roth IRA accumulation $110,992 minus traditional IRA accumulation $108,785 = $2,207 greater accumulation if she converts traditional into Roth IRA. d. In general terms, reconcile your answer from part (b) with your answer to part (c) (no numbers required). In both parts b and c, the taxpayer’s marginal tax rate is higher in the year of the conversion than 20 years later when the taxpayer withdraws the funds. In part b, the non-conversion option provides a larger accumulation. In part c, the conversion option provides a greater accumulation. The difference between part b and part c is the after-tax rate of return on the investments outside the retirement accounts (she must pay taxes with funds outside the retirement account because she rolled the entire amount in the traditional IRA into the Roth IRA). The low after-tax rate of return in part c reduces the opportunity cost of paying current taxes under the conversion option to the point where it more than offsets the decrease in the taxpayer’s marginal tax rate from the current year to year 20. 77. [LO 4] {Research} Sarah was contemplating making a contribution to her traditional individual retirement account for 2020. She determined that she would contribute $6,000 to her IRA, and she deducted $6,000 for the contribution when she completed and filed her 2020 tax return on February 15, 2021. Two months later, on April 15, Sarah realized that she had not yet actually contributed the funds to her IRA. On April 15, she went to the post office and mailed a $6,000 check to the bank holding her IRA. The bank received the payment on April 19. In which year is Sarah’s $6,000 contribution deductible? Sarah is allowed to deduct $6,000 in 2020. According to Rev. Rul. 84-18, an individual may deduct a contribution to an IRA (under §219) even though the contribution is made after the individual’s tax return is filed, as long as the contribution is made before the due date of the return. The next issue is whether Sarah’s contribution was made by the due date of her return (April 15, 2020). According to IRS Letter Ruling 8536085, June 14, 1985, contributions mailed by a taxpayer on or before the tax return deadline are considered as though they were timely made. 78. [LO 5] {Planning} Elvira is a self-employed taxpayer who turns 42 years old at the end of the year (2020). In 2020, her net Schedule C income was $130,000. This was her only source of income. This year, Elvira is considering setting up a retirement plan. What is the maximum amount Elvira may contribute to the self-employed plan in each of the following situations? a. She sets up a SEP IRA. b. She sets up an individual 401(k). a. $24,163. Elvira’s SEP IRA contribution is limited to the lesser of (1) $57,000, or (2) 20% of her net schedule C income (minus the deduction for self-employment taxes paid). The second limitation is computed as follows: Elvira’s net Schedule C income was $130,000. Her deduction for her self-employment taxes paid is $9,184, computed as follows: $130,000 × .9235 = $120,055. The social security limit for 2020 is $137,700. Consequently, her self-employment tax is $18,368 ($120,055 × .153). Elvira can deduct 50% of the self-employment taxes she paid. In this situation, Elvira’s self-employment tax deduction is $9,184 ($18,368 × 50%). Thus, the second limit for her SEP IRA contribution is $24,163 [($130,000 minus 9,184) × 20%]. b. $43,663. For taxpayers under 50 years of age, the limit for contributions to an individual 401(k) are the same as for SEP IRAs plus $19,500 for the employee contribution. Therefore, the maximum amount that Elvira may contribute is $43,163 ($24,163 (see solution to part a) + $19,500). 79. [LO 5] {Planning} Hope is a self-employed taxpayer who turns 54 years old at the end of the year (2020). In 2020, her net Schedule C income was $130,000. This was her only source of income. This year, Hope is considering setting up a retirement plan. What is the maximum amount Hope may contribute to the self-employed plan in each of the following situations? a. She sets up a SEP IRA. b. She sets up an individual 401(k). a. $24,163. Hope’s SEP IRA contribution is limited to the lesser of (1) $57,000, or (2) 20% of her net schedule C income (minus the deduction for self-employment taxes paid). The second limitation is computed as follows: Hope’s net Schedule C income was $130,000. Her deduction for her self-employment taxes paid is $9,184, computed as follows: $130,000 × .9235 = $120,055. The social security limit for 2020 is $137,700. The self-employment tax on $120,055 is $18,368 ($120,055 × .153). Hope can deduct 50% of the self-employment taxes she paid. In this situation, Hope’s self-employment tax deduction is $9,184 ($18,368 × 50%). Thus, the second limit for her SEP IRA contribution is $24,163 [($130,000 minus $9,184) × 20%]. The additional contribution amount for age does not apply to the SEP IRA contribution limit. b. $50,163. The limit on 401(k) contributions for taxpayers 50 years of age or older is the same as the SEP contribution (see part a. above) plus $26,000 (which includes a $6,500 catch-up contribution permitted for a 401(k) for taxpayers 50 years of age or older and a $19,500 employee contribution). Therefore, the maximum amount that Hope may contribute is $50,163 ($24,163 + $26,000). 80. [LO 5] Rita is a self-employed taxpayer who turns 39 years old at the end of the year (2020). In 2020, her net Schedule C income was $300,000. This was her only source of income. This year, Rita is considering setting up a retirement plan. What is the maximum amount Rita may contribute to the self-employed plan in each of the following situations? a. She sets up a SEP IRA. b. She sets up an individual 401(k). a. $57,000. Contributions to SEP IRAs are limited to the lesser of (1) $57,000 or (2) 20% of net schedule C income (minus deduction for self-employment taxes). The second limitation is computed as follows: Rita’s net Schedule C income was $300,000. Her deduction for her self-employment taxes paid is $12,555, computed as follows: $300,000 × .9235 = $277,050. The social security limit for 2020 is $137,700. The self-employment tax on $137,700 is $21,068 ($137,700 × .153). The self-employment tax on the remaining $139,350 ($277,050 minus $137,700) is $4,041 ($139,350 ×.029). Rita can deduct 50% of the self-employment taxes she paid. In this situation, Rita’s self-employment tax deduction is $12,555 [($21,068 + $4,041) × 50%]. Thus, the second limit for her SEP IRA contribution is $57,489 [($300,000 minus $12,555) × 20%]. Consequently, her SEP IRA contribution deduction is limited to $57,000. b. $57,000. Contributions to individual 401(k)s are limited to the lesser of (1) $57,000 or (2) 20% of net schedule C income (minus deduction for self-employment taxes) plus $19,500. Thus, Rita may contribute the lesser of (1) $57,000 or (2) $76,989 [$57,489 (see computation to part a) + $19,500]. So, her maximum contribution is $57,000. 81. [LO 5] Reggie is a self-employed taxpayer who turns 59 years old at the end of the year (2020). In 2020, his net Schedule C income was $300,000. This was his only source of income. This year, Reggie is considering setting up a retirement plan. What is the maximum amount he may contribute to the self-employed plan in each of the following situations? a. He sets up a SEP IRA. b. He sets up an individual 401(k). a. $57,000. Contributions to SEP IRAs are limited to the lesser of (1) $57,000 or (2) 20% of net schedule C income (minus deduction for self-employment taxes). The second limitation is computed as follows: Reggie’s net Schedule C income was $300,000. His deduction for his self-employment taxes paid is $12,555, computed as follows: $300,000 × .9235 = $277,050. The social security limit for 2020 is $137,700. The self-employment tax on $137,700 is $21,068 ($137,700 × .153). The self-employment tax on the remaining $139,350 ($277,050 minus $137,700) is $4,041 ($139,350 ×.029). Reggie can deduct 50 percent of the self-employment taxes he paid. In this situation, Reggie’s self-employment tax deduction is $12,555 [($21,068 + $4,041) × 50%)]. Thus, the second limit for his SEP IRA contribution is $57,489 [($300,000 minus $12,555) × 20%]. Consequently, his SEP IRA contribution deduction is limited to $57,000. Age does not affect his contribution limitation for a SEP IRA. b. $63,500. Contributions to individual 401(k)s are limited to the lesser of (1) $57,000 or (2) 20% of net schedule C income (minus deduction for self-employment taxes) plus $19,500. Taxpayers who are 50 years of age or older at year end can contribute an additional $6,500 beyond the normal limits. Thus, before considering the age catch up adjustment Reggie may contribute the lesser of (1) $57,000 or (2) $76,989 [$57,489 (see computation to part a) + $19,500]. So, his maximum contribution is $63,500 ($57,000 plus an additional $6,500 for age). 82. [LO 6] Desmond is 25 years old, and he participates in his employer’s 401(k) plan. During the year, he contributed $3,000 to his 401(k) account. What is Desmond’s saver’s credit in each of the following alternative scenarios? a. Desmond is not married and has no dependents. His AGI after deducting his 401(k) contribution is $34,000 b. Desmond is not married and has no dependents. His AGI after deducting his 401(k) contribution is $17,500. c. Desmond files as a head of household and has AGI of $44,000. d. Desmond and his wife file jointly and report an AGI of $30,000 for the year. a. Because Desmond is not married and has AGI greater than $32,500, he is not entitled to any saver’s credit. b. Desmond is allowed a saver’s credit of $1,000. Desmond contributed $3,000 to a qualified plan. However, only the first $2,000 of contributions counts towards the saver’s credit. Because Desmond is not married and has AGI below $19,500, his applicable percentage for computing the saver’s credit is 50%. So, Desmond’s credit is 50% of the $2,000 maximum contribution that counts towards the credit. c. Desmond is allowed a saver’s credit of $200. Desmond contributed $3,000 to a qualified plan. However, only the first $2,000 of contributions counts towards the saver’s credit. Because Desmond files as a head of household and has AGI of $44,000, his applicable percentage for computing the saver’s credit is 10%. So, Desmond’s credit is 10% of the $2,000 maximum contribution that counts towards the credit. d. Desmond is allowed a saver’s credit of $1,000. Desmond contributed $3,000 to a qualified plan. However, only the first $2,000 of contributions counts towards the saver’s credit. Because Desmond files as married filing jointly and has AGI of $30,000, his applicable percentage for computing the saver’s credit is 50%. So, Desmond’s credit is 50% of the $2,000 maximum contribution that counts towards the credit. 83. [LO 6] Penny is 57 years old and she participates in her employer’s 401(k) plan. During the year, she contributed $2,000 to her 401(k) account. Penny’s AGI is $36,000 after deducting her 401(k) contribution. What is Penny’s saver’s credit in each of the following alternative scenarios? a. Penny is not married and has no dependents. b. Penny files as a head of household and she has three dependents. c. Penny files as a head of household and she has one dependent. d. Penny is married and files a joint return with her husband. They have three dependents. e. Penny files a separate tax return from her husband. She claims two dependent children on her return. a. Because Penny’s AGI is $36,000, she is over the limit of $32,500 and as a result is not entitled to any savers credit. The number of dependents is irrelevant for purposes of the saver’s credit, only filing status and AGI are pertinent in determining the amount of the saver’s credit. b. Since Penny files as head of household, her applicable percentage based on her AGI of $36,000 is 10%. Penny contributed $2,000 to a qualified plan. Also, the first $2,000 of contributions counts towards the saver’s credit. Therefore, Penny’s saver’s credit is $200 ($2,000 × 10%). The number of dependents is irrelevant for purposes of the saver’s credit, only filing status and AGI are pertinent in determining the amount of the saver’s credit. c. Since Penny files as head of household, her applicable percentage based on her AGI of $36,000 is 10%. Penny contributed $2,000 to a qualified plan. Also, the first $2,000 of contributions counts towards the saver’s credit. Therefore, Penny’s saver’s credit is $200 ($2,000 × 10%). The number of dependents is irrelevant for purposes of the saver’s credit, only filing status and AGI are pertinent in determining the amount of the saver’s credit. d. Since Penny files as married filing jointly, her applicable percentage based on her AGI of $36,000 is 50%. Penny contributed $2,000 to a qualified plan. Also, the first $2,000 of contributions counts towards the saver’s credit. Therefore, Penny’s saver’s credit is $1,000 ($2,000 × 50%). The number of dependents is irrelevant for purposes of the saver’s credit, only filing status and AGI are pertinent in determining the amount of the saver’s credit. e. Since Penny does not file as married filing jointly or as head of household (she files as married filing separately), based on her AGI of $36,000, she is not allowed to claim the credit. The number of dependents is irrelevant for purposes of the saver’s credit, only filing status and AGI are pertinent in determining the amount of the saver’s credit. Comprehensive Problems 84. Jacquiline is unmarried and age 32. Even though she participates in an employer-sponsored retirement plan, Jacquiline contributed $3,000 to a traditional IRA during the year. Jacquiline files as a head of household, her AGI before the contribution is $43,000, and her marginal tax rate is 12 percent. What is the after-tax cost of her $3,000 traditional IRA contribution? The after-tax cost of $3,000 contribution is $2,440 ($3,000 – $360 tax savings from deduction – $200 saver’s credit). Jacquiline’s before-tax cost of the contribution is $3,000. Because her MAGI does not exceed $65,000, she is allowed to deduct the $3,000 in full as a for AGI deduction. This saves her $360 in taxes ($3,000 × 12%). Further, Jacquiline qualifies for the saver’s credit. With her AGI of $40,000 ($43,000 – $3,000), she qualifies for a 10% credit on $2,000 of the $3,000 contribution. Thus, the saver’s credit saves her $200 in taxes ($2,000 × 10%). 85. Ian retired in June of 2019 at the age of 71. Ian’s retirement account was valued at $490,000 at the end of 2018 and $500,000 at the end of 2019. He has had all of his retirement accounts open for 15 years. What is Ian’s required minimum distribution for 2020 under each of the following alternative scenarios? a. Ian’s retirement account is a traditional 401(k) account. b. Ian’s retirement account is a Roth 401(k) account. c. Ian’s retirement account is a traditional IRA. d. Ian’s retirement account is a Roth IRA. a. $19,550. Because he turns 72 during 2020, Ian is required to receive a minimum distribution for 2020. Ian’s minimum distribution for 2020 is based on the balance of his traditional 401(k) account at the end of 2019 ($500,000) multiplied by the applicable percentage in the IRS Uniform Lifetime Table. Because he is 72 years old at the end of 2020, the applicable percentage is 3.91%. Consequently, Ian’s minimum distribution for 2020 is $19,550 ($500,000 × 3.91%). Note that even though this is a required minimum distribution for 2020, Ian is not required to receive this distribution until April 1, 2021. b. $19,550. Same as part a. Required minimum distribution requirements for Roth 401(k)s are the same as for traditional 401(k)s. c. $19,550. Ian’s must receive a required minimum distribution for 2020 because he turns 72 during 2020. Ian’s required minimum distribution for 2020 is based on the balance of his traditional IRA at the end of 2019 ($500,000) multiplied by the applicable percentage in the Uniform Lifetime Table. Because he is 72 years old at the end of 2020, the applicable percentage is 3.91%. Consequently, Ian’s minimum distribution for 2020 is $19,550 ($500,000 × 3.91%). Note that even though this is a required distribution for 2020, Ian is not required to receive this distribution until April 1, 2021. d. $0. There are no required minimum distributions for Roth IRAs. 86. Alex is 31 years old and has lived in Los Alamos, New Mexico, for the last four years, where he works at the Los Alamos National Laboratory (LANL). LANL provides employees with a 401(k) plan and for every $1 an employee contributes (up to 9 percent of the employee’s salary) LANL contributes $3 (a 3-to-1 match). The plan provides a six-year graded vesting schedule. Alex is now in his fifth year working for LANL, and his current year salary is $170,000. Alex’s marginal tax rate is 24 percent in 2020. Answer the following questions relating to Alex’s retirement savings in 2020. a. Assume that over the past four years, Alex has contributed $45,000 to his 401(k) and his employer has contributed $115,000 to the plan. The plan has an account balance of $175,000. What is Alex’s vested account balance in his 401(k)? b. Because Alex considers his employer’s matching contributions “free money,” he wants to maximize the amount of LANL’s contributions. What is the least amount Alex can contribute and still maximize LANL’s contribution? c. In need of cash to build a home theater, Alex withdrew $30,000 from his traditional 401(k) account. What amount of the withdrawal, after taxes and penalties, will Alex have available to complete his project? d. Assume that Alex contributes $10,000 to his traditional 401(k) account this year. Also assume that in 30 years, Alex retires (at age 61) and withdraws the $10,000 contribution made this year and all the earnings generated by the contribution. Also assume that his marginal tax rate at the time he retires is 24 percent. Ignore any prior or subsequent contributions to his plan. If Alex earns a 6 percent annual before-tax rate of return, what are his after-tax proceeds from the distribution? e. Assume that Alex is 74 years old at the end of the year, retired, and that his marginal tax rate is 24 percent. His account balance in his traditional 401(k) was $1,250,000 at the end of last year. What is the minimum distribution Alex must receive from his 401(k) account for this year? If Alex receives a $43,000 distribution for the year from his 401(k) account (his only distribution during the year) what amount will he be able to keep after taxes and penalties (if any)? a. Alex has a total vested balance in his account of $124,688 ($49,219 accrued benefit from employee contributions + $75,469 accrued benefit from employer contributions). The total accrued benefit in Alex’s account is $175,000. Alex’s contributions to the account are $45,000 and the employer’s contributions to the account are $115,000. Alex is fully vested in the accrued benefit attributable to his contributions. In this case, the accrued benefit attributable to his contributions is $49,219 ($175,000 × $45,000/$160,000). Because Alex has worked for his employer for four full years and his employer uses a 6-year graded vesting schedule, Alex is vested in 60% of the accrued benefit attributable to employer contributions. In this case, the accrued benefit attributable to employer contributions is $125,781 ($175,000 total benefit minus $49,219 benefit attributable to his contributions). So, Alex is vested in $75,469 ($125,781 × 60%) of the accrued benefit from employer contributions. b. $14,250 is the least amount Alex can contribute in order to receive the maximum contribution from LANL. To maximize LANL’s contribution, Alex should contribute an amount x that when combined with the 3-to-1 match will yield the maximum $57,000 employee plus employer contributions. That is, Alex should contribute x where x + 3x = $57,000. In this case, x is equal to $14,250. This amount is less than the 9% of salary limitation of $15,300 ($170,000 × 9%) and it is less than the maximum allowable employee contribution of $19,500. c. Alex will be taxed at 24% on the $30,000 withdrawal. Consequently, he will pay $7,200 in taxes ($30,000 × 24%). In addition, he must pay a 10% early distribution penalty of $3,000 on the $30,000 withdrawal. This leaves him with $19,800 after taxes ($30,000 – $7,200 – $3,000) to build his home theater. d. $43,651. Alex’s after-tax proceeds from the distribution are $43,651, calculated as follows: Description Amount Explanation (1) Before-tax contribution $10,000 Cost of contribution before tax savings (2) Future value factor × 1.0630 6% annual rate of return for 30 years (3) Future value of contribution $57,435 (1) × (2) Value of contribution/amount of distribution 30 years after contribution (4) Taxes payable upon distribution (13,784) (3) × 24% marginal tax rate After-tax proceeds from distribution $43,651 (3) + (4) Value of account minus taxes payable on distribution e. Because Alex is 74 at the end of the year and retired, he must receive a distribution of 4.2% of his account balance as of the end of last year. His account balance at the end of last year was $1,250,000. Thus, Alex’s minimum distribution is $52,500. However, Alex’s distribution was only $43,000. Consequently, he must pay a 50% penalty tax on the $9,500 ($52,500 – $43,000) amount he was required to receive but did not. Alex must pay income tax of $10,320 on the $43,000 distribution he did receive ($43,000 × 24%) and an additional $4,750 penalty tax on the amount he did not receive ($9,500 × 50%). In total, Alex must pay $15,070 ($10,320 + $4,750) in taxes and penalties on the $43,000 distribution. This leaves him with $27,930 after taxes ($43,000 – 15,070). Thus, this distribution would be effectively taxed at a marginal tax rate of 35.05% ($15,070/ $43,000) 87. Tommy (age 47) and his wife, Michelle (age 49), live in Columbus, Ohio, where Tommy works for Callahan Auto Parts (CAP) as the vice-president of the brakes division. Tommy’s 2020 salary is $360,000. CAP allows Tommy to participate in its nonqualified deferred compensation plan, in which participants can defer 15 percent of their salary for five years. Tommy also participates in CAP’s qualified 401(k) plan. Tommy’s current marginal tax rate is 24 percent and CAP’s current marginal tax rate is 21 percent. a. Assuming Tommy earns a 6 percent after-tax rate of return and he expects his marginal tax rate to be 30 percent in five years, what before-tax deferred compensation payment in five years would make him indifferent between receiving the deferred compensation payment or 15 percent of his salary now (ignore payroll taxes)? b. Assuming CAP has an 8 percent after-tax rate of return and expects its marginal tax rate to be 35 percent in five years, how much would it be willing to pay in five years to be indifferent between paying the deferred compensation or paying 15 percent of Tommy’s salary now (ignore payroll taxes)? c. Will Tommy and CAP be able to come to an agreement on deferring Tommy’s salary? d. Assume that Tommy and Michelle have AGI of $107,000 before IRA deductions for either spouse. The AGI includes $10,000 that Michelle earned working part time (but she does not participate in an employer-sponsored retirement plan). Tommy and Michelle file a joint return. What is the maximum deductible contribution Tommy and Michelle may make to a traditional IRA? e. Tommy has a balance of $55,000 in his traditional IRA. Due to some recent tax cuts, his marginal tax rate is 22 percent, so he would like to convert his traditional IRA into a Roth IRA. What are the tax consequences to Tommy if he takes $55,000 out of the IRA, pays the taxes due from the traditional IRA distribution, and contributes the what is left from the distribution to the Roth IRA? a. Tommy would be indifferent between receiving $54,000 now or $78,459 in five years, calculated as follows: Description Amount Explanation (1) Before tax benefit of receiving 15% of salary now (versus receiving deferred payment) $54,000 $360,000 × 15% (2) Tax on 15% of salary received now (12,960) (1) × 24% (3) After-tax benefit of receiving 15% of salary now $41,040 (1) + (2) (4) Future value of after-tax benefit from receiving 15% of salary now. $54,921 (3) × 1.065 To be indifferent between receiving 15% of his current salary and receiving a deferred compensation payment in five years, Tommy would need to receive a deferred compensation payment (DC) in five years that would provide him with $54,921 after-taxes. The amount of the payment is determined by solving for DC in the following equation: $54,921 = DC × (1 – .30). The deferred compensation payment is $78,459. b. CAP would be indifferent if it paid Tommy $54,000 now or $96,434, calculated as follows: Description Amount Explanation (1) Before-tax cost of paying 15% of Tommy’s salary currently. $54,000 $360,000 × 15% (2) Tax benefit from paying 15% of Tommy’s current salary (11,340) (1) × 21% (3) After-tax cost of paying 15% of Tommy’s current salary $42,660 (1) + (2) (4) Future value cost of paying 15% of Tommy’s current salary $62,682 (3) × 1.085 CAP should be indifferent between paying 15% of Tommy’s salary now or paying deferred compensation to Tommy in five years that costs it $62,682 after taxes. This amount of deferred compensation (DC) can be determined by solving for DC in the following equation: $62,682 = DC × (1 – .35). The deferred compensation payment is $96,434. c. Yes, Tommy would be willing to accept a minimum of $78,459 and CAP would be willing to pay a maximum of $96,434. They should be able to come to an agreement because no party will be worse off and at least one party will be better off with a deferred salary in this range. d. Because Michelle does not participate in an employer-sponsored retirement plan, she may make a maximum deductible contribution of $6,000 to her IRA. Tommy participates in an employer-sponsored retirement plan, so he is subject to AGI limitations. The maximum $6,000 is phased-out over a range of $104,000 – $124,000. The couple’s MAGI is 15% through the phase-out range [(107,000 – 104,000) / (124,000 – 104,000)] so he must phase out 15% of the maximum $6,000 contribution. As a result, Tommy may make a maximum deductible contribution of $5,100 to his IRA [$6,000 × (1 – .15)]. The couple may make a total $11,100 deductible contributions ($6,000 + $5,100) to their IRA. e. Tommy will have to pay taxes of $12,100 for taking the $55,000 out of the IRA ($55,000 × 22%). After taxes, this leaves $42,900 for Tommy to contribute to the Roth IRA. However, because he doesn’t contribute the full $55,000 distributed to him, he will also have to pay a 10% penalty tax on the $12,100 that he does not roll over. Therefore, he will have to pay a penalty tax of $1,210 ($12,100 × 10%). In total, he will pay $13,310 ($12,100 income taxes + $1,210 penalty tax) on the transaction. 88. Gerry (age 56) and Elaine (age 54) have been married for 12 years and file a joint tax return. The couple lives in an apartment in downtown Manhattan. Gerry’s father, Mortey, recently retired from Del Boca Vista Corporation (DBVC) where he worked for many years. Mortey participated in DBVC’s defined benefit plan. Elaine is an editor and works for Pendent Publishing earning an annual $150,000 salary in 2020. Gerry is a self-employed stand-up comedian, and had net business income of $46,000 in 2020. At the advice of their neighbor, Gerry, Elaine, and Mortey have come to you to for help in answering several retirement savings-related questions. a. The DBVC defined benefit plan specifies a benefit of 1.5 percent for each year of service, up to a maximum of 30 percent (20 years of service), of the average of the employee’s three highest consecutive calendar years of salary. Mortey worked for the company for 25 years and earned $75,000, $78,000, and $84,000 over his final three years of service. What is Mortey’s annual benefit from DBVC’s defined benefit plan? b. Elaine has worked at Pendent Publishing since January 1, 2015. The company offers a defined contribution plan. It matches 100 percent of employee contributions to the plan up to 6 percent of her salary. Prior to 2020 Elaine had contributed $40,000 to the plan and her employer had contributed $28,000 to the plan. In 2020, Elaine contributed $17,000 to her traditional 401(k). What is the amount of her employer’s matching contribution for 2020? Assuming the company uses a six-year graded vesting schedule, what is Elaine’s vested balance in the plan at the end of 2020 (For simplicity, disregard the plan’s earnings)? c. Elaine tells you that her employer has offered her $30,000 in 10 years to defer 10 percent of her current salary (defer $15,000). Assuming that the couple’s marginal tax rate is currently 32 percent, they earn an after-tax rate of return of 8 percent, and they expect their marginal tax rate to be 28 percent in 10 years, should Elaine accept her company’s offer? What is the minimum amount she should be willing to accept (ignoring nontax factors and payroll taxes)? d. Gerry has a SEP IRA and would like to contribute as much as possible to this account. What is the maximum contribution Gerry can make to his SEP IRA in 2020? e. Assuming Gerry had an individual 401(k), what is the maximum amount he could contribute to the plan in 2020? f. Gerry also has a traditional IRA with an account balance of $12,000. He would like to convert the traditional IRA to a Roth IRA. Gerry would like to pay the least amount of tax possible from the conversion. Assume the couple’s marginal tax rate is 32 percent. What is the least amount of tax Gerry will be required to pay on the conversion? g. Assume that Gerry converted his traditional IRA into a Roth IRA six years ago (rather than in 2020) when the balance was $8,000 and that the account balance is now $20,000. Gerry has not made any contributions to his Roth IRA (other than the original conversion from his traditional IRA). The couple is considering buying their first home and would like to pay as much down as possible. They have heard from their friends that they can take the funds from their Roth IRA and use it to buy their first home. Are their friends correct? What would you advise them to do? h. Assume that Gerry and Elaine each made total contributions of $20,000 to their qualified retirement accounts in 2020. Also assume that their AGI is $40,500. What is the amount of their saver’s credit for 2020? a. Mortey will receive the maximum 30% of the average of his three highest consecutive calendar years of salary, which is $79,000 [($75,000 + $78,000 + $84,000)/3]. Therefore, his annual benefit will be $23,700 ($79,000 × 30%). b. Pendant Publishing will make a matching contribution of $9,000 ($150,000 salary × 6% maximum match) and Elaine’s vested account balance is $86,600 at the end of 2020. Elaine automatically vests in her own contributions. She contributed $40,000 in prior years and $17,000 in 2020 for a total of $57,000. Because she has worked at Pendant for five years as of the end of 2020, she is vested 80% in her employer’s contributions. Her employer has contributed $28,000 in prior years and $9,000 in the current year for a total of $37,000. Thus, Elaine is vested in $29,600 of her employer’s contributions (80% × $37,000). Her total vested account balance is $86,600 ($57,000 vesting in personal contributions + $29,600 vesting in employer contributions) (note that we are disregarding the earnings in her account. She would be 100% vested in the earnings on her contributions and she would be 80% vested in earnings on her employer’s contributions). c. Elaine should not accept the employer’s offer because it ($30,000) is lower than the minimum amount she should be willing to accept which is $30,585, as calculated below: Description Amount Explanation (1) Before tax benefit if she does not defer salary (only portion of salary she could have deferred) $15,000 $150,000 × 10% (2) Tax on non-deferred salary (4,800) (1) × 32% (3) After-tax benefit of non-deferred salary $10,200 (1) + (2) (4) Future value of after-tax non-deferred salary $22,021 (3) × 1.0810 As shown in the calculations above, Elaine would accumulate $22,021 after taxes in 10 years by currently receiving the $15,000 salary. However, if Elaine were instead to choose to receive $30,000 in 10 years, based on her expected tax rate, Elaine would have $21,600 after-taxes [$30,000 payment × (1 – .28)]. Without considering nontax factors, Elaine would be better off to receive the current salary rather than the deferred payment. The minimum payment she should be willing to accept is the amount of deferred compensation (DC) that leaves her with $22,021 after taxes. This can be determined by solving for DC in the following equation: $22,021 = DC × (1 – .28). Minimum deferred compensation payment is $30,585. This would leave her indifferent between deferring the current salary and receiving the future payment (ignoring nontax consequences). d. $8,550. Gerry’s SEP IRA contribution is limited to the lesser of (1) $57,000, or (2) 20% of his net schedule C income (minus the deduction for self-employment taxes paid). The second limitation is computed as follows: Gerry’s net Schedule C income was $46,000. His deduction for his self-employment taxes paid is $3,250, computed as follows: $46,000 × .9235 × .153 × .50 = $3,250. Thus, the second limit for Gerry’s SEP IRA contribution is $8,550 [($46,000 minus 3,250) × 20%]. e. $34,550. This is the same computation as the SEP IRA deduction ($8,550-see part d) plus an additional $19,500 for the individual 401(k) + an additional $6,500 for taxpayers 50 years of age or older at year end. f. To avoid penalties on the distribution from his traditional IRA, Gerry needs to roll the entire account balance into a Roth IRA within 60 days of the distribution (he needs to put all $12,000 into the Roth IRA). However, Gerry will have to pay taxes on the withdrawal at his ordinary rates. Thus, Gerry will owe $3,840 in taxes due to rolling his traditional IRA into a Roth IRA ($12,000 × 32%). Note that he will have to pay these taxes in addition to the $12,000 he rolls into the Roth IRA. g. They are partially correct. Gerry could take out $8,000 (the value of the account he was taxed on when he converted into a Roth IRA) without being taxed or without being penalized. The remaining $12,000 in the account represent account earnings. Qualifying distributions from a Roth IRA are not taxed. Because Gerry is under 59½ years old, to be a qualifying distribution, the account needs to have been open for at least five years (it has been) and the distributions must be used to pay for qualified acquisition costs for first-time homebuyers. They meet both of these criteria. However, the amount used to pay for a first-time home is limited to $10,000. If Gerry pulls out the remaining $12,000 from the Roth IRA to pay for the home, $10,000 of this amount would be tax free and would not be penalized. However, the remaining $2,000 would be taxed at Gerry’s 32% marginal tax rate plus a 10% early distribution penalty (42% tax/penalty in total). To avoid paying tax and the penalty, the couple should only withdraw $18,000 (tax-free) consisting of $8,000 of Gerry’s original contribution to the Roth IRA plus the $10,000 first time home buyer qualified acquisition costs to use for their down payment. (Note that if Gerry and Elaine both had a Roth IRA, they could each withdraw up to $10,000 from their respective IRAs ($20,000 in total) to pay as for qualified acquisition costs). This would leave $2,000 in the Roth IRA.. h. $400 for Gerry and $400 for Elaine. Because both Gerry and Elaine contributed at least $2,000 to their qualified retirement account, both Gerry and Elaine would be eligible for a $400 credit ($800 in total for the couple). The credit is calculated by multiplying their applicable percentage of 20% (married couple AGI of $40,500) by the first $2,000 each spouse contributed to a qualified retirement account. Note that based on their actual AGI $196,000 (specified in the original facts), neither spouse would be eligible for any saver’s credit. Solution Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534
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