PFS Tax Planning 3 — Questions and Answers
Question 1: What is the primary tax advantage of a 529 college savings plan?
- Contributions are federally deductible
- Earnings grow tax-free and withdrawals are tax-free for qualified education expenses (Correct answer)
- The account avoids estate taxes entirely
- Distributions are taxed at the child's lower rate
Correct answer: Earnings grow tax-free and withdrawals are tax-free for qualified education expenses
529 plan earnings accumulate tax-deferred and distributions used for qualified education expenses are entirely federal-income-tax-free.
Question 2: A client converts $80,000 from a traditional IRA to a Roth IRA. The client has a basis of $20,000 in all traditional IRAs totaling $200,000. How much of the conversion is taxable?
- $80,000
- $72,000 (Correct answer)
- $60,000
- $20,000
Correct answer: $72,000
The pro-rata rule applies: basis ratio = $20,000 / $200,000 = 10%, so 10% of $80,000 ($8,000) is non-taxable and $72,000 is taxable.
Question 3: Which business entity structure avoids double taxation while offering limited liability to all owners?
- C corporation
- S corporation (Correct answer)
- General partnership
- Sole proprietorship
Correct answer: S corporation
An S corporation is a pass-through entity where income is taxed only at the shareholder level, avoiding the double taxation of a C corporation while providing limited liability.
Question 4: Under the kiddie tax rules, a 16-year-old dependent's unearned income above the threshold is taxed at:
- The child's marginal rate
- A flat 10% rate
- The parents' marginal rate (Correct answer)
- The capital gains rate regardless of holding period
Correct answer: The parents' marginal rate
The kiddie tax taxes a qualifying child's net unearned income above the threshold at the parents' marginal federal income tax rate.
Question 5: A taxpayer has $10,000 of short-term capital losses and $6,000 of long-term capital gains. What is the net tax result?
- $4,000 net short-term loss deductible against ordinary income up to $3,000 per year (Correct answer)
- $4,000 net long-term loss
- $6,000 ordinary deduction
- $10,000 fully deductible in the current year
Correct answer: $4,000 net short-term loss deductible against ordinary income up to $3,000 per year
Short-term losses first offset short-term gains, then long-term gains; the remaining $4,000 net capital loss is deductible up to $3,000 against ordinary income per year, with the rest carried forward.
Question 6: Which deduction is classified as an above-the-line deduction (adjustment to income) available to all eligible taxpayers, even those who do not itemize?
- Mortgage interest
- Charitable contributions
- Student loan interest (Correct answer)
- State income taxes
Correct answer: Student loan interest
Student loan interest of up to $2,500 is an above-the-line deduction available to eligible taxpayers regardless of whether they itemize, subject to income phase-outs.
Question 7: When evaluating whether to accelerate deductions or defer income, which concept best supports deferring income to next year?
- Time value of money — a tax paid later is worth less in today's dollars (Correct answer)
- Bunching strategy to exceed the standard deduction
- Step-up in basis at death
- Constructive receipt doctrine
Correct answer: Time value of money — a tax paid later is worth less in today's dollars
Deferring taxable income delays the tax payment, preserving the time value of money since future dollars are worth less than current dollars.
PFS Tax Planning 3
What is the primary tax advantage of a 529 college savings plan?