PFS Tax Planning 1 — Questions and Answers
Question 1: Which of the following is considered a tax-deferred retirement account?
- Roth IRA
- Traditional IRA (Correct answer)
- Health Savings Account
- Brokerage Account
Correct answer: Traditional IRA
A Traditional IRA is a tax-deferred retirement account, meaning contributions may be tax-deductible in the year they are made, and investment earnings grow tax-free until retirement. Taxes are only paid when withdrawals are made in retirement. In contrast, a Roth IRA offers tax-free withdrawals in retirement, while a Health Savings Account has specific medical expense usage rules, and a Brokerage Account is typically taxable annually.
Question 2: What type of income is typically subject to self-employment tax?
- Interest income
- Dividend income
- Wages
- Net self-employment income (Correct answer)
Correct answer: Net self-employment income
Self-employment tax, which funds Social Security and Medicare for self-employed individuals, is specifically calculated on an individual's net earnings from self-employment. This amount is derived from gross income earned through a trade or business, minus allowable business expenses. Interest income, dividend income, and wages (from an employer) are subject to different tax rules and are not included in this calculation.
Question 3: Which deduction can be claimed without itemizing deductions on a federal tax return?
- Mortgage interest
- Charitable contributions
- Standard deduction (Correct answer)
- Medical expenses
Correct answer: Standard deduction
The standard deduction is a fixed dollar amount that taxpayers can subtract from their adjusted gross income (AGI) to reduce their taxable income, without having to list out specific expenses. Taxpayers choose between taking the standard deduction or itemizing deductions (such as mortgage interest or charitable contributions), opting for whichever provides the greater tax benefit. It is a pre-set amount available to most taxpayers.
Question 4: Which tax strategy helps reduce taxable income by deferring it to a later year?
- Tax credit
- Tax exclusion
- Tax deferral (Correct answer)
- Tax deduction
Correct answer: Tax deferral
Tax deferral is a strategy that allows income or capital gains to grow without being taxed until a future date, typically when the funds are withdrawn. This is common in retirement accounts like Traditional IRAs or 401(k)s, where contributions and earnings are not taxed until retirement. By delaying taxation, investors can benefit from compounding growth on the full amount, potentially reducing their overall tax burden if they are in a lower tax bracket in retirement.
Question 5: Capital gains are typically taxed lower when assets are held for how long?
- Less than 3 months
- More than 6 months
- Over 1 year (Correct answer)
- Exactly 1 year
Correct answer: Over 1 year
Capital gains are classified as either short-term or long-term based on how long an asset is held before being sold. Assets held for "over 1 year" (more than 365 days) qualify for long-term capital gains tax rates, which are generally lower than ordinary income tax rates. Assets held for one year or less are considered short-term and are taxed at an individual's ordinary income tax rate, which is typically higher.
Question 6: Which of the following is a refundable tax credit?
- Mortgage interest deduction
- Earned Income Tax Credit (Correct answer)
- Charitable donation deduction
- Medical expense deduction
Correct answer: Earned Income Tax Credit
A refundable tax credit, such as the Earned Income Tax Credit (EITC), can reduce a taxpayer's liability below zero, potentially resulting in a tax refund even if no tax was owed. This means the taxpayer can receive money back from the government. Non-refundable credits and deductions (like mortgage interest or charitable donations) can only reduce tax liability to zero, but not below it.
PFS Tax Planning 1
Which of the following is considered a tax-deferred retirement account?