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1

George, age 50, bought a deferred fixed annuity, in 2008, for $150,000. This annuity would begin paying him $1,000 per month at age 65 for the rest of his life. The cash surrender value of the annuity is currently $400,000. However, George now wants to pay off college tuition loans for his daughter, Elaine. If George should withdraw, in a lump sum, the initial contract investment of $150,000 at age 58, how much of the withdrawal is taxable?

A. $0
B. $56,250
C. $90,000
D. $150,000

D.

The withdrawal is treated on a last-in, first-out (LIFO) basis. The withdrawal amount of $150,000 is considered fully-taxable interest to the extent the cash surrender value exceeds the investment in the contract. The 10% premature withdrawal penalty is also applied. In this situation, the entire $150,000 is taxable.

2

A client, Andrea, is a single individual with significant income and potential deductions. She has provided her CFP® professional with the following information for the year 2021:

„ Salary: $100,000
„ Dividends: $5,000
„ Long-term capital gains: $10,000
„ Long-term capital losses: $13,000

„ Municipal bond interest: $8,000
On the basis of the data given, how much adjusted gross income (AGI) does Andrea have?

A. $96,000 B. $102,000 C. $104,000 D. $110,000

B.

Andrea’s AGI is $102,000 ($100,000 of salary + $5,000 of dividends – $3,000 capital loss). The municipal bond interest is not taxable. The net long-term capital loss of $3,000 (LTCG $10,000 – LTCL $13,000 = net LTCL $3,000) reduces gross income to $102,000.

3

Assume that, in the current year, an investor has the following:

„ Investment interest expense of $5,000
„ Investment income (bond interest) of $2,600
„ Investment adviser’s fees of $1,400

Assume that the investor has an AGI of $40,000. Which of these investment interest expense amounts may be deducted in the current year?

A. $1,400 B. $2,600 C. $4,000 D. $5,000

B.

A total of $2,600, the investment interest expense up to the amount of net investment income, may be deducted in the current year. The remaining $2,400 may be carried forward. The investment adviser’s fees are not deductible, and do not impact the calculation.

4

Stan files as married filing jointly (MFJ) with his spouse, Marie. It is September of the current year and his year-to-date compensation working at Jack Sprat, Inc., is $205,000 for this last payroll period. How much of his compensation is subject to the Additional Medicare Tax withholding so far this year?

A. $0 B. $5,000 C. $200,000 D. $205,000

B.

Even though taxpayers who file as MFJ do not incur the Additional Medicare Tax until their income exceeds $250,000, employers are required to begin withholding the tax when an employee first has compensation exceeding $200,000, disregarding the employee’s filing status. The 0.9% tax is levied on the excess above $200,000. In this case, that amount is $5,000.

5

Which of these statements made by each client’s financial advisor is CORRECT?

I. Bill is self-employed as a sole proprietor and has two employees. He can take a deduction for his own salary withdrawals from his business as well as the salary for his employees.
II. Crosby is an employee−shareholder in an S corporation. Crosby’s salary, net income, and expenses on his K−1 from the business are subject to the 0.9% Additional Medicare Tax.
III. Lucy has elected to have her LLC taxed as a C corporation so her distributed dividends will only be taxed once.
IV. Marla is concerned about liability issues and using any losses she may incur early in the formation of her business. She has selected the S corporation form as a best fit.

IV only.

Because items of income and expense flow-through to the shareholder, any early losses will be deductible by the taxpayer. The corporation form will also provide protection from liability issues of the S corporation for Marla. Statement I is incorrect. Bill’s withdrawals are not a deductible expense. They are part of his Schedule C net income. Statement II is incorrect. If Crosby’s salary is in excess of the thresholds for the Additional Medicare Tax, it would be levied against his salary only, not on his net income derived from his K–1. Statement III is incorrect. If Lucy selects the regular or C corporation form for her LLC, the income will be taxed twice, once at the corporate level and again on her personal income tax return for any distributed dividends.

6

Susie, a student, has been accepted to an Ivy League school. Her parents, Mary and Carlos, expect to pay tuition of at least $50,000 per year. Susie will be claimed as their dependent. Susie’s grandparents have gifted her $30,000 of Series EE bonds to help pay tuition. Which of these is the most advantageous for Mary and Carlos to claim on their tax return?

A. American Opportunity Tax Credit
B. Lifetime Learning Credit
C. Student loan interest deduction
D. Educational exemption for Series EE bonds

A

Mary and Carlos may claim the $2,500 American Opportunity Tax Credit to cover their share of expenses. The Lifetime Learning Credit is only $2,000 and cannot be claimed in the same year as the AOTC. Because of the grandparents’ contribution, there is not a need to take out a sizable student loan. This interest is also often deferred until graduation. Therefore, it is not a viable strategy for the current tax year. No one can claim the savings bond exemption in this example because the bonds were originally purchased by her grandparents who cannot claim Susie as a dependent.

7

Five years ago, Greg Young, age 55, purchased a deferred annuity that is estimated to pay him $900 per month for the rest of his life, beginning at age 65. His investment in the contract was a one-time payment of $150,000. The assumed rate of return on the contract is 4%.

Which one of the following is an income tax implication of the deferred annuity for Greg?

A) The annuitized distribution amount consisting of Greg’s investment in the contract is a tax-free return of capital.
B) Tax-free nonperiodic distributions are allowed for education or family illness
C) Earnings within the annuity are taxable in full each year to Greg as ordinary income.
D) Withdrawals in a nonperiodic distribution are first allocated to the tax-free investment in the annuity.

A.

A nonperiodic distribution or withdrawal from a post-August 13, 1982, annuity contract is treated on a last-in, first-out (LIFO) basis. In other words, to the extent that the cash surrender value exceeds the investment in the contract, taxable interest income is treated as being withdrawn first. There are no provisions that allow for a tax-free withdrawal for education or illness. The earnings on the investment in a commercial annuity are deferred—there is no current taxation on the earnings within the contract as long as an individual is the owner (or treated as an owner) of the contract.

8

Fred has investment income (interest and dividends) of $9,000 in the current tax year. He paid $1,000 in broker commissions on security purchases and $1,800 in investment adviser fees, and he has incurred $8,500 of investment interest expense. His AGI was $25,000. What amount of investment interest expense may be deducted as an itemized deduction?

$8,500

Investment interest expense is deductible up to the amount of Fred's investment income. Because there is only $8,500 of investment interest expense, it is completely deductible.

9

Rob has an investment interest expense carryforward of $3,500 from a prior tax year. For the current tax year, he has an AGI of $75,000, $4,000 of investment interest expense, and $9,500 of investment income. He has investment adviser's fees of $5,000. How much investment interest expense, if any, may Rob deduct in the current tax year?

$7,500

Investment interest expense is deductible up to the amount of investment income. The investment income is $9,500. Rob has total investment interest expense of $7,500. All of that is currently deductible. The Tax Cuts and Jobs Act (TCJA) repealed the Tier II miscellaneous itemized deductions, so there is no adjustment necessary for the other investment expenses.

10

Hardship withdrawals are only allowed from Section 401(k) plans if specifically stated in the plan document and typically for expenses including which of the following?

I. Vacation costs
II. Medical expenses
III. College tuition costs
IV. Insurance premiums

II & III

Hardship withdrawals are typically allowed for medical expenses, college tuition and fees, the purchase of a principal residence, burial expenses for a spouse or dependents, and to prevent eviction from one's principal residence or foreclosure on the mortgage of such residence.

11

Larry has owned 100 shares of Positive Publishing Inc. stock since September 15, 2017. His basis in the 100 shares is $15,000. Larry sold these shares on March 15, 2021, for $12,500. After hearing a positive earnings report for the Positive Publishing stock, he purchases 100 more shares on April 11, 2021, for $13,000.

What is the basis in the shares purchased on April 11, 2021?

$15,500

The sale at a loss and the subsequent repurchase of substantially identical shares within a period of 30 days before 30 days after the date of the loss sale results in a wash sale. This causes a disallowance of the loss. The basis of the newly acquired security is increased by the amount of the disallowed loss from the wash sale. The $2,500 disallowed loss is added to the $13,000 purchase price to give a basis of $15,500.

12

Which of the following statements regarding the dividends-received deduction is CORRECT?

I. The amount of the dividends-received deduction is based on the percentage owned of the dividend-paying corporation by the corporation receiving the dividend.
II. The dividends-received deduction is specific to corporations.

I & II

13

Which one of the following is an exception to the general rule that life insurance proceeds are excluded from income?

A) The cash value accumulation rule
B) The corridor rule
C) The transfer for value rule
D) The cash guideline premium rule

C.

The only exception to the general rule that life insurance proceeds are excluded from income is the transfer for value rule, which applies when a life insurance contract is transferred for valuable consideration.

14

In 2011, Jack Meyers, a married taxpayer filing jointly, purchased U.S. Series EE savings bonds for $4,000. During 2021, when Jack was 40 years old, he redeemed the bonds to help pay for his dependent son's college tuition. The accrued value at the time of redemption was $5,000. Assume Jack pays $9,200 of tuition expenses during the year. The 2021 AGI is $100,000.

What are the tax consequences upon the redemption of the bonds?

A) There is insufficient information given to determine the tax consequences.
B) All the interest may be excluded.
C) A portion of the interest may be excluded.
D) All accrued interest is taxable in the current year.

B.

The exclusion begins to phase out at an AGI of approximately $125,000 ($124,800) for joint filers for 2021. The phaseout information will be provided on the examination. The other requirements for exclusion of the interest are also met: purchased by an individual 24 years of age or older, redeemed to pay for qualifying higher-education expenses of a dependent, taxpayer, or spouse. The other limitation, EE redemption proceeds greater than qualified expenditures, does not apply here.

15

Pam paid $31,000 in premiums on an endowment life insurance policy with a face value of $90,000. In the current year, upon reaching age 70, Pam received the face value of the policy. For tax purposes, how much income, if any, will Pam report?

$59,000

The cancellation of the endowment policy causes taxation on the difference between the amount received, the cash surrender value, and the investment in the contract, the premiums paid.

16

STUDY NOTE

The exclusion for interest on EE bonds redeemed to pay for qualifying higher-education expenses applies only to bonds purchased by an individual age 24 or older. Ken is 28 years old; the bonds were purchased approximately seven years ago, when Ken was approximately age 21.

17

You are working with new financial planning clients, Dan and Patrice Harden, on educational funding issues for their three dependent children. Dan and Patrice will file jointly this year, as they have always done, and anticipate an AGI of $110,000. Their oldest child, Ben, age 23, is in his first year of graduate school studying to be a pharmacist. Ben graduated from college in three years, so the American Opportunity Tax Credit was claimed for three years of Ben's education. Their middle child, Margaret, age 19, had a conviction for felony drug possession last year. She's "cleaned up her act" and will be a full-time student at a community college this year. Their youngest child, Francis, age 7, is a good kid who wants to be a doctor when he grows up.

Which of the following statements concerning educational tax credits and incentives is CORRECT?

I. Ben and Margaret would each qualify for the American Opportunity Tax Credit (AOTC).
II. Ben and Margaret would each qualify for the Lifetime Learning Credit.
III. Dan and Patrice may make a contribution to a Coverdell account for Francis.
IV. Only Ben would qualify for the Lifetime Learning Credit.

II & III

Ben and Margaret both qualify for the Lifetime Learning Credit. The Lifetime Learning Credit may be claimed for graduate studies, and may be claimed for a child with a felony drug conviction. Note that the Lifetime Learning Credit would allow a total of $10,000 of education expenses to be utilized on Dan and Patrice's tax return. (The Lifetime Learning Credit limitation of $10,000 is applied per return, whereas the AOTC limitation of $2,500 is per student.) The parent(s) who claims a child as a dependent is entitled to take the tax credit for the educational expenses of the child. The AGI is under the phaseout thresholds for the Lifetime Learning Credit. Even though the AOTC may generally be claimed for four years, Ben does not qualify for the AOTC because it may not be claimed for graduate work, only the first four years of undergraduate work. The AOTC may not be claimed for a child who has a felony drug conviction, so Margaret does not qualify for the AOTC. Dan and Patrice may make a Coverdell contribution for Francis, because their AGI does not exceed the phaseout limit of $190,000 to $220,000 for a married couple filing jointly. (The AGI limitations will be provided on the examination.)

18

Gary Anderson bought 1,000 shares in a mutual fund for $30 per share. Later that year, the fund declared a dividend of $2.50 per share. Gary elected to have dividends from the fund reinvested to purchase additional shares at $28 per share. Gary has a capital loss carryforward from a prior year and would like to maximize the use of the carryforward.

What is the maximum amount of taxable gain Gary can incur if he later sells 1,000 shares for $33 per share?

$3,447

The difference between the sales price of the shares held and the basis of the shares held determine gain. The maximum gain would involve the sale of the 89.29 shares obtained with the distribution reinvestment and 1,000 of the original shares. The basis of the 89.29 shares is $2,500, and the basis of the other shares is $30,000, for a total of $32,500. Compared to the sale price of $35,947 (rounded), there is a gain of $3,447.

19

Kerri, a single taxpayer who itemizes deductions, incurred $5,000 in management fees relating to her taxable investments. Her AGI is $100,000, which includes $20,000 of investment income. How much investment expense (Section 212 expense) can she deduct for this year?

$0

Investment expenses other than investment interest expenses are not deductible.

20

Which one of the following statements regarding education provisions is CORRECT?

A) Higher-education expenses for the Section 529 plan may include expenses for a computer, software, and internet access
B) The annual contributions to a Coverdell account may not exceed $2,000 per donor.
C) Qualifying expenses for the American Opportunity Tax Credit (AOTC) include tuition, books, supplies, and room and board.
D) The American Opportunity Tax Credit applies to undergraduate and graduate courses at an accredited, Title IV institution.

A.

Qualifying expenses for the AOTC do not include room and board. The AOTC may only be used for the first four years of undergraduate or vocational courses. Qualified higher-education expenses for Section 529 purposes include tuition, books, fees, and equipment for enrollment at an eligible educational institution; expenses for special needs services; and room and board costs for students who are at least half-time. In addition, expenses for the purchase of computer or peripheral equipment (printer, modem, etc.), computer software, or internet access and related services may be treated as qualifying expenses if the equipment, software, or services are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution. The annual contributions to a Coverdell account may not exceed $2,000 per beneficiary.

21

Jim Jannsen purchased a deferred variable annuity several years ago. His investment in the annuity contract was $48,000. His current life expectancy, based on IRS tables, is 20 years. During the current year, he received annuity payments totaling $5,400.

What amount of the annuity payments is taxable to Jim?

$3,000

The investment in the contract ($48,000) is divided by the life expectancy (20 years) to equal the amount of the variable annuity excluded ($2,400 per year). Thus, of the $5,400 received, $2,400 is excluded, and the remaining $3,000 is taxable.

22

Martha borrowed $40,000 from a bank, using the money for investment purposes. Of that $40,000, she invested $20,000 in tax-exempt municipal bonds and $20,000 in taxable corporate bonds. Which of the following statements regarding Martha is CORRECT?

A) Martha can deduct the interest on $20,000 of the loan for tax purposes.
B) Martha can deduct the interest on $40,000 of the loan for tax purposes.
C) Martha is engaging in an illegal activity.
D) Martha can deduct none of the interest on the loan for tax purposes.

A.

The IRS does not allow taxpayers to deduct interest on borrowed funds when those funds are used to generate tax-exempt income. Because Martha used $20,000 of the loan to purchase taxable securities, the interest on that $20,000 is deductible as an investment interest expense.

23

For two years, Lisa Carson was able to pay the premiums on her whole life policy without borrowing. For the past two years, she has borrowed from the cash value of her whole life policy to pay the premiums. Last year, she paid $95 of interest on the funds she borrowed.

What are the tax implications in this situation?

A) The interest is deductible because Lisa is in the business of continuing her insurance and the interest is deductible business interest expense.
B) The interest expense is not tax deductible.
C) The interest expense is not tax deductible because it does not exceed $100.
D) The interest expense is tax deductible because it does not exceed $100

B.

The interest expense is not tax deductible because interest on a loan incurred to purchase personal life insurance protection is considered personal interest, which is not deductible. Personal loan interest is not tax deductible, regardless of whether the lender is a bank or a life insurance company.

24

Cash value life insurance is often structured like an investment vehicle. However cash value life insurance contains important features that shelter the inside buildup from taxation. Which of the following will NOT be considered when determining whether a policy can maintain its tax favored status?

A) The death benefit
B) The cash guideline premium test and corridor test
C) The premium value test
D) The cash value accumulation test

C.

Without a death benefit, a contract does not meet the legal definition of life insurance. There are currently two tests—only one of which must be met—in order to classify a product as life insurance for federal income tax purposes: (1) the cash value accumulation test and (2) the cash guideline premium test and corridor test. There is no premium value test.

25

Which of the following statements correctly defines inside buildup as it refers to life insurance?

A) During the insured’s lifetime, the accumulations of cash value within a policy grow on a tax-deferred basis.
B) During the insured’s lifetime, the accumulations of cash value within a policy grow on a tax-annuitized basis.
C) During the insured’s lifetime, the accumulations of cash value within a policy grow on a tax-free basis.
D) During the insured’s lifetime, the accumulations of cash value within a policy grow on a tax-preferred basis.

A.

Accumulations of cash value within a life insurance policy grow on a tax-deferred basis during the insured's lifetime.

26

In 1991, John Idler purchased a single premium whole life insurance policy. In the current year his medical expenses are $15,000 and his AGI is $75,000. What is the tax implication to John if he borrows the interest from the policy's accumulated cash value to pay his current year's medical expenses?

A) John will not be required to report the amount borrowed as income, but he will be allowed a medical expense deduction.
B) John will be required to report the amount borrowed as income, but he will not be allowed a medical expense deduction.
C) John will be required to report the amount borrowed as income and will be allowed a medical expense deduction.
D) John will not be required to report the amount borrowed as income and will not be allowed a medical expense deduction.

C.

Amounts borrowed on a single premium whole life policy issued on or after June 21, 1988 (a MEC), are taxable on a last-in, first-out basis; thus, the earnings would be taxable. A medical expense deduction will be allowed regardless of the source of the funds, since the payment would be for a valid medical expense.

27

Matthew Brady, age 47, purchased a deferred annuity in January 1982 for $50,000. In the current year, when the surrender value was $125,000, Matthew took a nonperiodic distribution of $75,000. Which one of the following statements correctly describes the income tax consequences of the distribution?

A) $50,000 is taxable, $25,000 is tax free.
B) $50,000 is tax free, $25,000 is taxable.
C) $75,000 is tax free.
D) $75,000 is taxable income.

B.

The pre-August 14, 1982, annuity retains first-in, first-out (FIFO) treatment. Thus, the basis of $50,000 is treated as being withdrawn first and is tax free. The remaining $25,000 is taxable. If this were a post-August 13, 1982, contract, it would be treated on a last-in, first-out (LIFO) basis.

28

Which one of the following is a characteristic of a fixed annuity contract?

A) The annuitant pays now for future fixed or variable payments.
B) If a corporation owns the annuity contract, the earnings are not tax deferred.
C) Fixed annuity contracts are not tax advantaged, unlike other annuity contracts.
D) The buyer may choose among a handful of investment options.

B.

With a fixed annuity contract, there is no ability to select the investment options; the payments are fixed. Fixed annuity contracts are generally tax advantaged (tax deferred), unless a corporation owns the annuity contract, in which case the earnings are currently taxable. Such is also the case with a variable annuity.

29

Which one of the following statements is incorrect regarding investment interest expense?

A) Investment interest expense is deductible up to the amount of the net investment income.
B) Interest paid or accrued to purchase or carry tax-exempt investments is not deductible.
C) Excess investment interest expense cannot be carried forward into succeeding tax years.
D) Net investment income is the taxpayer’s investment income—typically interest, nonqualified dividends, and short-term capital gains

C.

Excess investment interest expense can be carried forward into succeeding tax years. Investment interest expense is deductible up to the amount of net investment income. The interest on funds borrowed to purchase tax-exempt investments is not deductible. The net investment income is typically interest, nonqualified dividends, and short-term capital gains. Long-term capital gains and qualified dividends may be included at the taxpayer's election, but the taxpayer must forgo the preferential tax rates on these items.

30

Sheila, a single taxpayer, has taxable income of $470,000. Included in the taxable income is $50,000 of qualified dividends. At what rate(s) will her qualified dividends be taxed?

A) 20% only
B) 15% and 20%
C) 15% only
D) 25%

B.

The qualified dividends straddle the $445,850 breakpoint (for 2021). Thus, a portion fall into the $40,401 to $445,850 range and are taxed at 15%. The dividends above the $445,850 breakpoint are taxed at 20%.