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Series 7 exam Ch 17 Taxes
Taxation.
132
Finance
Professional
12/16/2012
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Term
Types of Taxes: SALES TAXES
 Definition
SALES TAXES are one of the states’ greatest revenue sources.
Term
SALES TAXES
 Definition
a regressive tax: specified products and services By state and local GOVT
Term
EXCISE TAXES is a regressive tax.
 Definition
taxes on the manufacture, sale, or consumption of nonessential (or excess) commodities within the United States such as liquor, tobacco, and gasoline.
Term
regressive tax
 Definition
because it taxes everyone equally
Term
The two types of property taxes are:
 Definition
Real estate taxes
called AD VALOREM TAXES, are the primary income source to make interest and principal payments on GENERAL OBLIGATION BONDS.
Term
Property tax is based on the MIL RATE
 Definition
with 1 mil = $0.001 cents per $1.00 of assessed value. The property is assessed and the mil rate is applied to either the actual assessed value or to a percentage of the assessed value, depending on the charter of the municipality.
Term
PERSONAL PROPERTY TAXES
 Definition
are taxes on personal property, such as boats and recreational vehicles and, in a business, all of the assets such as machines and furniture. The money from this tax goes into the GENERAL FUND.
Term
The GENERAL OBLIGATION BOND FUND
 Definition
is used to pay the MUNICIPAL DEBT OBLIGATIONS (MUNICIPAL BONDS) of the municipality.
Term
The GENERAL FUND
 Definition
is used to pay for general municipal services (police and fire departments, city hall, and so on).
Term
ESTATE TAXES
 Definition
are levied on the estate of a deceased person by the federal government and some state governments.
•
Estate taxes are considered PROGRESSIVE TAXES
Term
PROGRESSIVE TAXES.
 Definition
This is because the higher the value of the estate, the more the estate is taxed.
Term
INCOME TAXES are considered progressive taxes:
 Definition
because the more income a person earns, the higher the percentage tax the person will pay.
Term
Both sales taxes and gasoline taxes are considered REGRESSIVE TAXES
 Definition
because the rate applied to each purchase is the same for everyone, regardless of their income.
Term
Both income tax and estate taxes are considered PROGRESSIVE TAXES
 Definition
because the rate of taxation increases as the value of the estate increases or as a person’s income increases. With a progressive tax, the theory is that wealthier individuals or estates are capable of paying a higher rate of tax.
Term
Which of the following are regressive taxes?

I.
Gasoline
II.
Sales
III.
Estate
IV.
Income
 Definition
(A)
I and II only
(B)
III and IV only
(C)
I and III only
(D)
II and IV only
Answer
(A) I and II only. Gasoline and sales taxes are regressive because they are the same percentage for everyone and, therefore, hit the poorest people the hardest.
2.0
Term
The U.S. Tax Code currently classifies all income and losses as one of three types:
 Definition
ORDINARY: Income or losses from activities of an individual or business.
Term
The U.S. Tax Code currently classifies all income and losses as one of three types:PASSIVE: Income or losses from activities in which the individual does not actively participate.
 Definition
income from property that is managed by someone else, losses from depreciation and depletion, and capital gains and losses upon sale of the limited partnership or any other properties that are managed by a third party.
Term
PORTFOLIO or INVESTMENT The last kind of the three incomes:
 Definition
Income or losses from dividends or interest on investments, as well as capital gains and losses upon the sale of securities. The dividends are taxed as ordinary income and if the dividend is from a U.S. corporation, it is taxed at a maximum of 15%;
Term
ORDINARY INCOME following four components:1)SALARY
 Definition
1)SALARY and/or WAGES: Annual personal income
Term
ORDINARY INCOME following four components:2)OTHER EARNED INCOME:
 Definition
2)OTHER EARNED INCOME: Other sources of income, such as consulting or side jobs
Term
ORDINARY INCOME following four components:3)UNEARNED INCOME:
 Definition
3)Interest on bank accounts and income from property that is owned and managed by the taxpayer
Term
ORDINARY INCOME following four components:4)LOSSES:
 Definition
4)LOSSES: Losses on property that is owned and managed by the taxpayer
Term
PASSIVE LOSSES
 Definition
CAN NEVER be used to offset ordinary income at any time.
may offset income from other partnerships or income from passive capital gains upon the sale of other partnerships.
Term
In a portfolio, CAPITAL GAINS and CAPITAL LOSSES are made when assets
 Definition
such as stocks, bonds, and limited partnerships, are purchased and sold.
Term
SHORT-TERM CAPITAL GAIN/LOSS
 Definition
The asset is considered to be held short term when it is owned for one year or less. 12 months
Term
LONG-TERM CAPITAL GAIN/LOSS.
 Definition
The asset is considered to be held long term when it is owned for at least one year and one day. 366 days
Term
Short Sale of stock and the writing (selling) of options always have a short-term holding period
 Definition
Investors never own the stock, nor do they own the option.
Term
The AMT TAX PREFERENCE ITEMS for the ALTERNATIVE MINIMUM TAX are: 1
 Definition
Intangible drilling costs= IDCs
Term
The AMT TAX PREFERENCE ITEMS for the ALTERNATIVE MINIMUM TAX are: 2
 Definition
The amount of percentage depletion in excess of cost depletion like in an oil well.
Term
The TAX PREFERENCE ITEMS for AMT 3:
 Definition
Accelerated depreciation — known as “depreciation”
Term
The AMT TAX PREFERENCE ITEMS for the ALTERNATIVE MINIMUM TAX are: 4
 Definition
Interest on municipal bonds that are for private use, such as some revenue bonds and IDR bonds
Term
ALTERNATIVE MINIMUM TAX (AMT)
 Definition
High-income taxpayers who have many deductions must determine the ALTERNATIVE MINIMUM TAX (AMT). If the alternative minimum tax is greater than the taxpayer’s regular income tax, the taxpayer must pay the alternative minimum tax amount.
Term
A CAPITAL GAIN
 Definition
A CAPITAL GAIN occurs when an asset is sold for MORE than it was purchased.
Term
A CAPITAL LOSS
 Definition
occurs when the asset is sold for LESS than it was purchased.
Term
COST BASIS
 Definition
To determine the amount of gain or loss, subtract the cost of the property
Term
TREATMENT OF CAPITAL GAINS
 Definition
sale of an asset results in a gain, the gain must be classified as either a SHORT-TERM GAIN or a LONG-TERM GAIN.
Term
If a short-term gain is realized,
 Definition
add the whole gain to the taxpayer’s ordinary income; the gain is taxed at the taxpayer’s income tax bracket.
Term
If a long-term gain is realized,
 Definition
the whole gain is only taxed at a maximum of 15%
The holding period of all capital gains begins on the trade date and ends on the trade date.
Term
TREATMENT OF CAPITAL LOSSES
 Definition
sale of an asset results in a loss, it must also be classified as either a LONG-TERM LOSS or a SHORT-TERM LOSS to balance against gains.
Term
If the final result is a loss,
 Definition
can be deducted from ordinary income up to a limit of $3,000 per year.
Term
If the capital loss is more than a $3,000,
 Definition
the amount in excess of the $3,000 is carried forward to the next tax year.
Term
When taxpayers have more than one investment with gains or losses,
 Definition
the gains are netted (offset) against losses dollar for dollar up to any amount.
Term
Income from portfolio assets or investments is known as PORTFOLIO INCOME and includes
 Definition
dividends on stock, mutual funds and REITS, and interest on bonds.
Term
Taxed at a maximum of 15%.
 Definition
Dividends received from investments in stocks of domestic corporations (companies in the United States) and from mutual funds
Term
taxed at the taxpayer’s income tax bracket.
 Definition
However, dividends from REITS, and foreign corporations, as well as interest on debt issues are considered portfolio income
Term
An investor who receives dividends from a corporation in a foreign country may have to pay a tax to that country.
 Definition
If this is the case, the tax paid in the foreign country becomes a tax credit to the investor when paying taxes in the U.S. on this foreign

dividend.
Term
Remember that a tax credit reduces the taxes owed, and
 Definition
therefore reduces the amount of tax paid due to the dividend.
Term
An investor has $8,000 in short-term gain, $12,000 in short-term loss, $15,000 in long-term gain, and $4,000 in long-term loss. What is the tax consequence for the investor who is in the 28% tax bracket?
FIRE Drill
(A)
Short-term deduction of $3,000, long-term tax liability of $2,200
(B)
Short-term deduction of $3,000, long-term tax liability of $1,650
(C)
Tax liability of $1,505
(D)
Tax liability of $1,050
 Definition
Answer
(D) Tax liability of $1,050. First, match short-term versus short-term and long-term versus long-term; then match short-term versus long-term. Then calculate the tax. In this case:
+$8,000 - $12,000 = -$4,000
+$15,000 - $4,000 = +$11,000
+$11,000 - $4,000 = +$7,000 × 15% maximum long-term capital gains rate. This results in a tax liability of $1,050.
Term
CORPORATE BONDS
 Definition
All interest from CORPORATE BONDS is added to income and taxed at the investor’s tax rate.
Term
CORPORATE BONDS purchased at a discount matures
 Definition
all gains are taxable at both the federal and state level as ordinary income.
Term
CORPORATE BONDS Upon sale of a discount bond prior to maturity,
 Definition
all gains will be part ordinary income and part capital gain/loss, depending on the sale price in relation to the adjusted cost basis.
Term
U.S. GOVERNMENT BONDS
 Definition
All interest from U.S. GOVERNMENT BONDS is exempt from taxes at the state and local levels, but is added to the investor’s income for federal taxes only.
Term
U.S. GOVERNMENT BONDS purchased at a discount matures:
 Definition
all gains are taxable at both the federal and state level as

ordinary income.
Term
Upon sale of a discount bond prior to maturity
 Definition
all gains will be part ordinary income and part capital gain/loss, depending on the sale price in relation to the adjusted cost basis.
Term
All interest from MUNICIPAL BONDS is exempt from taxation at the federal level,
 Definition
but is added to the investor’s income at the state level.
Term
Municipal bonds are also exempt from state and local taxes in the state in which they are issued,
 Definition
but are not exempt in any other state.
Term
The exam may ask questions that describe the investor being a resident in the same state as the issue
 Definition
If so, the investor is exempt from both federal and state tax if the municipality and the investor are located in the same state.
Term
When a Muni bond purchased at a discount matures,
 Definition
all gains are taxable at both the federal and state level as ordinary income.
Term
Upon sale of a discount bond prior to maturity,
 Definition
all gains will be part ordinary income and part capital gain/loss, depending on the sale price in relation to the adjusted cost basis.
Term
Use this equation to find the equivalent yields: corporate or municipal bond
 Definition
CORPORATE BOND YIELD =
MUNICIPAL BOND YIELD/100% - TAX BRACKET %
Term
Example
Always remember to use the yield, NOT the coupon in determining the equivalent yield.

A person in the 28% tax bracket wants a corporate bond equivalent to a municipal bond with a 7.5% yield.
 Definition
CORPORATE BOND YIELD = MUNICIPAL BOND YIELD
100% - TAX BRACKET%
= 7.5%
100% - 28%
= 7.5%
72%
= 10.42%
Term
All municipal notes are short-term,
 Definition
issued at a discount, and mature at par value. The appreciation from its discounted price to its par value at maturity is the interest that is earned by the investor. Therefore, there is no capital gain on municipal notes held until maturity.
Term
BONDS OF TERRITORIES AND PROTECTORATES
The bonds of territories and protectorates include bonds issued, for example, by state or municipal authorities in Puerto Rico and Guam.
 Definition
The interest on these bonds is TRIPLE EXEMPT. This means that the interest is not taxed at any level: Federal, state, or local.
Term
TAX TREATMENT OF ALL BONDS
 Definition
it will never be a capital loss or capital gain if held to maturity.
Term
When investors buy a bond at a premium either as new issue or in the secondary market, and hold the bond until maturity,
 Definition
they cannot take a capital loss at maturity.
Term
corporate or government bond,
 Definition
the investor can amortize the premium over the years until maturity and deduct the amortized amount of loss each year against the interest income received.
Term
Examples
1. David purchases an 11% 10-year corporate bond for $1,100. The bond is held until maturity. What is the gain or loss at maturity?
 Definition
Since David can deduct the amortized premium against the interest income at maturity, there is no capital loss.
Term
2. Emily purchases a 6% 10-year municipal bond for $1,100. The bond is held until maturity. What is the gain or loss at maturity?
 Definition
Since Emily has purchased a municipal bond, she must amortize the premium without taking any deductions, and there is no capital loss at maturity. The IRS just does not allow the loss. The thinking is that the interest is tax-free; therefore, no deduction is given for the premium.
Term
When a bond is purchased at a original issue discount (OID)The original issue discounted amount represents the amount of interest that will be received.
 Definition
It is the difference between the purchase price and the maturity price (par value) that accumulates between the time the bond is originally sold until it matures.
Term
If the bond is a municipal bond,ODO
 Definition
the accreted amount is treated as the interest credited to the municipal bond and is, therefore, tax-free.
Term
If the bond is a corporate bond,ODO
 Definition
the accreted amount is the interest credited to the bond and, therefore, must be claimed as interest income each year.
Term
A zero-coupon bond is a form of an OID bond.
 Definition
Therefore, there is no capital gain if held to maturity.
Term
Example
Susan buys a corporate zero-coupon bond for $400 with 15 years to maturity. If the bond is held to maturity, what will be her capital gain?
 Definition
ZeroAnswer: $0. The bond must be accreted $40 per year ($1,000 - $400 = $600 ÷ 15 years = $40 of accretion per year) and is taxed as ordinary income.
Therefore, the last year also has $40 interest; however, there is no capital gain.
Term
If the bond is a zero-coupon bond purchased at a discount and sold prior to maturity,
 Definition
there could be a gain or loss in addition to the interest credited to the bond.
Term
Eric buys a corporate zero-coupon bond for $400 with 15 years to maturity. If the bond is held one year and sold for $500, what will he have?
 Definition
Answer: $40 interest, $60 capital gain. The interest is calculated as in the previous example. The bond must be accreted at $40 per year ($1,000 - $400 = $600 ÷ 15 years = $40 of accretion per year). So, after the first year, the bond has accreted to $440. Therefore, the capital gain is everything above $440. Since the bond was sold for $500, there is a $60 capital gain ($500 - $440).
Term
All bonds (municipal, corporate, and government) bought at a discount in the secondary market have the accreted gain taxed
 Definition
as ordinary income if held to maturity.
Term
The accreted gain is a “straight-line” accretion
 Definition
that is added to the cost of the bond each year.
Term
The accretion can be taxed each year or taxed when the bond is sold or matures.
 Definition
The investor has the choice.
Term
OPTIONS If options go UNEXERCISED, the premium is treated as:

For options positions that are short (short call or short put),
 Definition
the gain is a short-term capital gain in the year the option expires.
Term
For options positions that are long (long call or long put),
 Definition
the loss is a short-term capital loss in the year the option expires.
Term
Closing Options Positions
 Definition
the resulting gain or loss is always a short-term capital gain or loss.
Term
If an option that is either purchased or written is EXERCISED, the premium of the option is:
 Definition
ADDED to the STRIKE PRICE to determine the COST BASIS or PROCEEDS if the option is a CALL (buy or sell respectively) find the break even point
Term
If an option that is either purchased or written is EXERCISED, the premium of the option is:
 Definition
SUBTRACTED from the STRIKE PRICE to determine the COST BASIS or PROCEEDS if the option is a PUT (sell or buy respectively)
Term
Example
Write a 70 call for a premium of 5; when exercised, the writer’s proceeds are $7,500 per option contract.
 Definition
Since it is a call, to calculate the proceeds, add the premium to the call price of 70. Remember, “call up.” The premium received was $500. If a call that is written by an investor is exercised, the writer must sell the shares at the strike price, which in this case is $70. If 100 shares are sold at $70, the proceeds would be $7,000. If we add the premium that was received for the call option, the total proceeds equal $7,500.
Term
Example
Buy a 70 call for a premium of 5; when the buyer of a call exercises the option, the premium (5) is added to the 70 strike price in determining the cost basis of the stock.
 Definition
Again, think “call up.”
Term
For an investor who writes a PUT OPTION, the premium is subtracted from the cost of the stock when the option is exercised and the investor is forced to purchase the stock.
 Definition
Example
Write a 70 put for a premium of 5; when exercised, the writer’s cost basis of the stock is $6,500.
To calculate a put, subtract the premium from the put price of 70. Remember, “put down.”
Term
Example
Buy a 70 put for a premium of 5; when the buyer of a put exercises, the premium (5) is subtracted from the 70 strike price in determining the proceeds of the stock.
 Definition
Again, think “put down.”
Term
Regardless of whether the investor is a buyer or a writer, to find the cost basis or the proceeds, remember “call up” for calls and “put down” for puts.
 Definition
If the option is a call, whether buy or sell, add the premium to the strike price; if the option is a put, whether buy or sell, subtract the premium from the strike price.
Term
An investor writes a 70 call option for a premium of 9. If the investor is exercised when the stock is at $85, what are the investor’s proceeds?
FIRE Drill
(A)
$600
(B)
$6,100
(C)
$7,900
(D)
$8,500
 Definition
Answer
(C) $7,900. This question is asking for the proceeds, not the capital gain. The proceeds are the amount the investor receives in the transaction; in this case, $70 per share when exercised and $9 per share for the premium for a total of $79 per share, or $7,900
Term
SHORT SALES
 Definition
are always considered a SHORT-TERM CAPTIAL GAIN or LOSS when the position is closed because the customer never owns the stock since the stock was borrowed to deliver for the short sale.
Term
A WASH SALE is defined as selling a security at a loss and purchasing or repurchasing the same security (or a substantially similar security) within
 Definition
30 days before or after the sale of that security.
Term
A WASH SALE is defined as
 Definition
Purchasing an in-the-money call option on a stock position that has been sold within this time frame is also considered a wash sale.
Term
A WASH SALE is
 Definition
Selling an in-the-money put option on a stock position that has been sold within this time frame is also considered a wash sale.
Term
A WASH SALE is
 Definition
If either the call or put is out of the money, a wash sale is not invoked because the stock is not guaranteed to be repurchased at the lower price.
Term
The IRS does not allow investors to recognize a loss when they execute a wash sale.
 Definition
Example
Henry buys 100 shares of stock at $60 for a total of $6,000. Toward the end of the year, he calculates that an investment loss could reduce his tax liability. The stock that he previously purchased is currently selling at $50 per share. He sells the stock on December 23 at $50 per share, for a total of $5,000. Then on January 5 of the next year (less than 30 days later), he buys 100 shares of the stock again at $49. The IRS does not allow the $1,000 loss.
Term
For the test, look for a wash sale any time you see a specific date on which a trade is made!
 Definition
For the test, look for a wash sale any time you see a specific date on which a trade is made!
Term
INVESTMENT COMPANY TAXATION
Dividend and Interest Distributions
 Definition
15%
All dividends distributed to investment company shareholders are taxable to the shareholder at a maximum of 15% if the dividends are from a U.S. corporation.
Term
15% is the same rate as dividends to stock shareholders of other U.S. corporations.
 Definition
All interest distributed to shareholders is taxable to shareholders as ordinary income in the year distributed.
Term
All capital gains that are distributed by an investment company (mutual fund)
 Definition
are treated as long-term capital gains and taxed in the year received. The gain is always treated as a long-term gain, even if the mutual fund was only held for a short time (less than one year).
Term
CORPORATE EXCLUSION
 Definition
Corporations do not pay any federal income tax on interest from municipal issues
Term
Corporations have a partial exclusion on dividends received from preferred and common stock holdings:
 Definition
of other corporations
Term
Any amount donated to a UNIFORM GIFTS TO MINORS ACT (UGMA)UGMA/UTMA(UNIFORM TRANSFER TO MINORS ACT) by one donor in excess of $13,000 is taxable to the donors as a gift tax.
 Definition
An unlimited value of gifts can be given to a minor in an UGMA account. However, the maximum gift-tax-free gift to a minor per donor per year is $13,000. Therefore, a husband and wife can give $13,000 each, or $26,000 total, to a child.
Term
Any income earned by a minor in an UGMA account is taxable to the minor
 Definition
at the minor’s income tax rate in the year it is paid.
The same rules apply to a gift given to another adult.
Term
When securities are given to a minor (or any other person) as a gift from a living person, the cost basis
 Definition
in the securities for the donor becomes the cost basis to the minor (or other person) who receives the securities.
Term
Example:
A father gives his daughter 200 shares of stock that are presently trading at $50 per share, for a total of $10,000. The father paid $30 per share when he purchased the stock. The cost basis for the daughter is $30 per share.
 Definition
The value of the gift, for gift tax purposes, is the value of the securities as of the date the securities are given: $10,000. The cost basis is the original cost to the father, or $6,000.
Term
When securities are given to a minor (or any other person) because of a “last will” from a deceased person, the cost basis
 Definition
to the minor (or other person) who receives the securities is the value on the date of death of the person who bequeaths the stock.
Term
Example:
A father dies and leaves his daughter 200 shares of stock that were trading at $50 per share on the date of his death, for a total of $10,000.
 Definition
The stock is trading at $60 when the shares are given to the daughter. The father paid $30 per share when he purchased the stock. The cost basis to the daughter upon sale of the stock is $50 per share, the value on the date the father died.
Term
Donations to charities may qualify as a deduction from ordinary income.
 Definition
If the donated property has been held for one year or less, the original cost basis of the property (usually stock) is all that can be deducted.
Term
Donations to charities may qualify as a deduction from ordinary income.
 Definition
If the property has been held for more than one year, the market value on the date of the gift is the amount that can be deducted.
Term
Investors who live in the United States but invest in stocks and bonds of companies in foreign countries
 Definition
must pay federal taxes on the dividends and interest received.
Term
The investor may also have to pay taxes to the country
 Definition
where the company is located.
Term
If US investors pay taxes to the country where the company is located,
 Definition
The Get a Tax Credit based upon the amount of taxed paid in that country on US Taxes.
Term
Qualified plans are retirement plans where the contribution is deposited prior to paying taxes, and thus we say the contributions are tax-deferred. Examples are:
 Definition
401(k) plans
•
Defined benefit and defined contribution plans
•
Profit sharing plans
•
Keogh plans
Term
Nonqualified plans are retirement plans where the contribution is deposited after the participant has paid taxes on the money that will be contributed. Thus, we say the contributions are NOT tax deferred.
 Definition
Examples are:
•
Variable annuities
Term
In a NONQUALIFIED retirement plan, the contributions are NOT tax-deferred
 Definition
since income tax has already been paid on that money, and withdrawals of this money will not be taxed or penalized at any time.
Term
QUALIFIED retirement plan, the contributions ARE tax-deferred,
 Definition
the income tax has yet to be paid, and withdrawals of this money will ALWAYS be taxed, and penalized if certain conditions have not been met.
Term
the appreciation accrues tax-deferred
 Definition
both qualified and nonqualified retirement plans,meaning that upon withdrawal, a tax must be paid on the appreciation.
Term
10% penalty tax is charged on the amount withdrawn that has been deferred.
 Definition
if the contributor has not yet reached age 59 1/2,
Term
The amount that is taxed as ordinary income also has an extra 10% penalty tax.
 Definition
The amount withdrawn with after-tax dollars is not taxed, nor is there a penalty tax.
Term
Remember, for a withdrawal from both qualified and nonqualified plans,
 Definition
the penalty tax is only on the same amount that is subject to ordinary income tax.
Term
A person in a NONQUALIFIED retirement plan who takes a partial withdrawal is first considered to be taking the amount that has appreciated in the account,
 Definition
and then the rest of the withdrawal is considered the cost basis. Thus, the first dollars taken are taxed as ordinary income up to the amount appreciated, and then all other dollars taken are tax-free as return of cost basis.
Term
Example
A person has contributed $50,000 to a nonqualified plan. The plan has risen to $60,000. Since this is a nonqualified plan, only the amount taken up to $10,000 is taxed, plus penalty where applicable. The person is now 45 and wants to take a withdrawal of $8,000. How is the withdrawal taxed?
 Definition
$8,000 is taxed as ordinary income plus a 10% penalty.
The person is now 45 and wants to take a withdrawal of $12,000. How is the withdrawal taxed?
$10,000 is taxed as ordinary income plus a 10% penalty; $2,000 is not taxed as it is the contribution that already has been taxed.
The person is now 65 and wants to take a withdrawal of $8,000. How is the withdrawal taxed?
$8,000 is taxed as ordinary income and there is no 10% penalty.
The person is now 65 and wants to take a withdrawal of $12,000. How is the withdrawal taxed?
$10,000 is taxed as ordinary income and there is no 10% penalty; $2,000 is not taxed as it is the contribution that already has been taxed.
Term
must pay ordinary income on the whole amount. (Note the difference between this and a non-qualified plan.)
 Definition
A person in a QUALIFIED retirement plan who takes a partial withdrawal is taking the whole amount as untaxed
money,

Therefore, depending on the age of the person, the amount taken is taxed as ordinary income only, provided the person is 59 1/2 or older, or as ordinary income plus a 10% penalty tax if the person has not yet reached 59 1/2.
Term
Example
A person has contributed $50,000 to a qualified plan. The plan has risen to $60,000. Since this is all pre-tax dollars that are taken, it is all going to be taxed, plus a penalty where applicable. The person is now 45 and wants to take a withdrawal of $8,000. How is the withdrawal taxed?
 Definition
$8,000 is taxed as ordinary income plus a 10% penalty.
The person is now 45 and wants to take a withdrawal of $12,000. How is the withdrawal taxed?
$12,000 is taxed as ordinary income plus a 10% penalty.
The person is now 65 and wants to take a withdrawal of $8,000. How is the withdrawal taxed?
$8,000 is taxed as ordinary income with no 10% penalty.
The person is now 65 and wants to take a withdrawal of $12,000. How is the withdrawal taxed?
$12,000 is taxed as ordinary income with no 10% penalty.
Term
There are six ways that a person is allowed to take withdrawals from both a nonqualified and a qualified plan without a penalty, of which you only need to know five:
 Definition
In the case of death or disability
Term
allowed to take withdrawals from both a nonqualified and a qualified plan without a penalty,
 Definition
To pay for higher education for someone in the family (even nieces and nephews)
Term
allowed to take withdrawals from both a nonqualified and a qualified plan without a penalty,
 Definition
To purchase or remodel a first home
Term
a person is allowed to take withdrawals from both a nonqualified and a qualified plan without a penalty Number 5
 Definition
Taking payments that equate to a retirement
Term
when withdrawals must be made.Qualified plans
 Definition
must start taking contributions by April 1 in the year AFTER the person has turned 70 1/2. (If a person turns 70 on April 29 and 70 1/2 on October 29, this person must start taking withdrawals periodically or all at once by April 1 the following year.)
Term
when withdrawals must be made.
 Definition
Nonqualified plans do not ever have to start taking money from the plan, regardless of age.
Term
A person has contributed $100,000 to a nonqualified plan over the last 20 years. The plan has risen to $600,000. The person is now 45 and wants to take withdrawals that equate to a retirement. How are the withdrawals going to be taxed?
 Definition
Since part of this is with after-tax dollars and the appreciation is with pre-tax dollars, part of each payment is the return of cost basis and another part is taxed. No penalty tax is incurred.
Term
Rick Jones has contributed $80,000 to his nonqualified retirement plan. After 10 years, the account has appreciated to $100,000. Rick, who is 50 years old, and his wife need to withdraw $30,000 from the plan as a down payment on their new house. How much tax will they pay if they are in the 28% tax bracket?
FIRE Drill
(A)
$3,800
(B)
$5,600
(C)
$7,600
(D)
$8,400
 Definition
Answer
(C) $7,600. The investor is buying a new home, not a first home. This is a nonqualified plan, thus only the appreciation is taxed, and since he is under 59 1/2, they will have to pay a penalty tax of 10% on the same amount that is taxed as ordinary income. In this case, $20,000 is taxed at 28% plus a penalty of 10%. 20,000 × 38% = 7,600.
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