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TCP CPA Practice Questions Explained: Traditional IRAs

Traditional IRAs

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In this video, we walk through 5 TCP practice teaching about traditional IRAs. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

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Traditional IRAs

Traditional IRAs (Individual Retirement Accounts) offer a way for individuals to save for retirement with potential tax advantages. Here’s a detailed overview that explains key aspects of Traditional IRAs, including compensation requirements, penalties for early withdrawals, exceptions to those penalties, Required Minimum Distributions (RMDs), and the excise tax on missed RMDs.

Taxable Compensation for Traditional IRAs

For an individual to contribute to a Traditional IRA, they must have taxable compensation. This includes wages, salaries, bonuses, commissions, tips, and net income from self-employment. Taxable alimony received under divorce or separation agreements in effect before 2019 also counts as compensation. However, investment income such as interest, dividends, and capital gains, as well as pension or annuity income, do not qualify as compensation.

Example: If Jane, a freelance graphic designer, earns $50,000 from her services in a year, she can contribute up to the annual limit to her Traditional IRA. However, if her income comes entirely from stock dividends and rental properties, she cannot make any IRA contributions because these are not considered compensation.

10% Penalty for Early Withdrawal

Withdrawals from Traditional IRAs before the age of 59.5 typically incur a 10% early withdrawal penalty. This penalty is intended to discourage individuals from using their retirement savings prematurely.

Exceptions to the Early Withdrawal Penalty:

  • Unreimbursed medical expenses that exceed 7.5% of adjusted gross income.
  • Health insurance premiums while unemployed.
  • Death or Disability: Withdrawals made after the death of the IRA owner or if the owner becomes disabled.
  • Higher education expenses: Payments for tuition, fees, books, supplies, and equipment required for enrollment or attendance.
  • First-time home purchase: Up to $10,000 can be used towards buying, building, or rebuilding a first home.
  • IRS levy: Amounts withdrawn because of an IRS levy on the IRA.

Example: Exceptions to the Early Withdrawal Penalty

Michael, who is 53 years old, decides to withdraw $30,000 from his Traditional IRA to cover several significant expenses. He’s concerned about the 10% early withdrawal penalty, as he is not yet 59.5 years old. Here’s how Michael can potentially avoid the penalty based on the specifics of his withdrawal:

  1. Medical Expenses: Michael had major surgery earlier in the year, resulting in $24,000 of unreimbursed medical expenses. Since these expenses exceed 7.5% of his adjusted gross income (AGI) of $80,000 (7.5% of $80,000 is $6,000), he can withdraw up to $18,000 ($24,000 – $6,000) from his IRA without penalty to cover these costs.
  2. Higher Education Expenses: Michael also wants to support his daughter’s college education. This year, her tuition and related educational expenses (books, supplies) amount to $10,000. He can withdraw this amount from his IRA without facing the early withdrawal penalty, as payments for higher education expenses for himself, his spouse, or dependents qualify for an exemption.

Calculation:

  • Total Withdrawal: $30,000
  • Exempt Withdrawals:
    • Medical Expenses: $18,000
    • Higher Education Expenses: $10,000

Required Minimum Distributions (RMDs) and Excise Tax

Starting at age 72, IRA holders must begin taking RMDs, which are minimum amounts that a retirement plan account owner must withdraw annually. The RMD amount is calculated based on the account balance and life expectancy factors provided by the IRS.

If the full amount of the RMD is not withdrawn by the deadline, a 50% excise tax is applied to the amount not distributed as required. This tax is meant to ensure that retirement funds are not merely accumulated but are actually used for retirement.

Example: If Lisa has an IRA valued at $100,000 and her RMD for the year is calculated to be $3,900 but she only withdraws $2,000, she will be subject to a 50% excise tax on the $1,900 not withdrawn. This means she will owe an additional $950 in excise tax.

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