Wk 3: Income Tax

The tips deduction and the overtime deduction: amounts, caps, and where they sit in the formula.

Two "other below the line" deductions (Schedule 1-A), available whether or not you itemize. • Tips: up to $25,000 per return, every filing status. Cash tips only, in an occupation on Treasury's list, voluntary and reported. • Overtime: up to $12,500 ($25,000 MFJ). Only the premium portion counts (the "half" in time-and-a-half). Each is capped first, then phased out separately. Both are still subject to payroll tax; this is an income-tax break only.

How is the tips/overtime deduction phased out, and what is the rounding wrinkle?

The capped deduction is reduced by $100 for every $1,000 of AGI (before the deduction) above $300,000 MFJ or $150,000 for everyone else: (AGI − threshold) ÷ 1,000 × $100. High earners lose it entirely. Rounding: the book's examples round the quotient down (11.5 → 11, a $1,100 reduction); the slides' Justin example rounds 37.4 up to 38. Both give $0 in Justin's case, so only the book shows a true tie-breaker. Cards here follow the book; confirm with the professor.

Justin earns $20/hour and time-and-a-half ($30) for overtime. He worked 210 overtime hours and was paid $6,300 for them. How much is eligible for the overtime deduction?

Only the premium: $30 − $20 = $10/hour × 210 hours = $2,100, not the $6,300 of overtime wages. In the recommended problems the amounts given already "reflect the overtime component," so use them as the premium.

Practice problem: (a) Mario (single): $16,000 tips, $2,000 overtime, AGI $52,000. (b) Millie (single): $22,000 tips, $14,000 overtime, AGI $112,500. (c) ReyAnn and Bobbie (MFJ): overtime $23,000 + $21,000, AGI $329,300. Total deduction for each?

(a) Tips 16,000 (under the cap) + overtime 2,000 = $18,000; AGI below $150,000, no phase-out. • (b) Tips 22,000 + overtime capped at 12,500 = $34,500; no phase-out. • (c) Overtime 44,000 capped at 25,000 (MFJ). Excess AGI 29,300 → 29 (rounded down) × $100 = 2,900. Deduction $22,100. (Rounding up gives $22,000.)

What is the general rule for noncash compensation, and what is the exception?

General rule: an individual is taxed on any economic benefit received as compensation, even with no cash flow. (Quiz 3, Q1: "Noncash compensation is excluded from total income" is false.) Exception: statutorily defined fringe benefits are excluded from income and exempt from payroll tax, while the employer still deducts their cost.

What is a nontaxable fringe benefit worth in salary terms? (The "pretax value" formula.)

To buy the same thing yourself you would need salary that leaves the cost after tax: pretax value = after-tax cost ÷ (1 − marginal rate). The higher your marginal rate, the more a nontaxable benefit is worth. A $12,000 benefit is worth $15,789 of salary at 24% and $19,048 at 37%.

Practice problem: HD provides free parking (worth $16/month to Aleena; Ike takes public transit) and family medical coverage (Aleena's equivalent cost $12,000; Ike's $8,550; premiums not deductible). Additional salary needed to buy these individually: (a) Aleena, 24% rate; (b) Ike, 37% rate?

(a) Parking 16 × 12 = 192, plus 12,000 = 12,192 ÷ (1 − 0.24) = $16,042. (b) Parking is worth nothing to Ike. 8,550 ÷ (1 − 0.37) = $13,571.

Practice problem: Peet provides free on-site day care. Pretax value for (a) Ms. Udolf, 32% rate, who would pay $7,990 for two children; (b) Mr. Zuo, 12% rate, who would pay $4,070 for one child?

(a) 7,990 ÷ 0.68 = $11,750. (b) 4,070 ÷ 0.88 = $4,625. Same benefit type, very different value, because the value of an exclusion scales with the marginal rate.

Which common fringe benefits are nontaxable (assume amounts are under any cap)?

Group term life insurance (coverage up to $50,000) • Qualified transportation, including parking (monthly max) • No-additional-cost services (free access to excess capacity) • Dependent care assistance (annual max) • Tuition assistance (annual max) • Medical and dental insurance coverage (no cap) Not on the list, so taxable: a moving allowance, personal use of a company car.

Restricted stock: when is it income, how much, and when does the employer deduct?

Stock is restricted if it is nontransferable and/or subject to a substantial risk of forfeiture (return it if you leave). Income = FMV at the earlier of the date it becomes transferable or the date the forfeiture risk lapses. Basis = income recognized. It is compensation subject to income and payroll tax. The employer deducts the same amount in its taxable year that includes the employee's inclusion date.

What does a §83(b) election do, what are its two risks, and when must it be filed?

A written election to include the stock's FMV at receipt in income now, despite the restrictions. Filed within 30 days of receipt. Nothing more is taxed when the restrictions lapse; later appreciation is capital gain. Risks: (1) you pay tax years early on a value you can't yet realize; (2) if the stock is later forfeited, no deduction is allowed. It can't be undone. Worth it when the stock is cheap now and expected to rise.

Practice problem: Sept 30, 2021: Stalling (fiscal year ending Aug 31) issues Harry 2,000 restricted shares, FMV $40,000; he can't dispose of them before Oct 1, 2026 and forfeits them if he leaves. On Oct 1, 2026 he sells them for $57,500. Stalling's deduction and year if (a) no election; (b) a timely §83(b) election?

(a) Harry's income is the FMV when the restriction lapses, Oct 1, 2026: $57,500. Stalling deducts $57,500 in the fiscal year that includes that date: FYE Aug 31, 2027. (b) Harry includes $40,000 in 2021. Stalling deducts $40,000 in the fiscal year that includes Sept 30, 2021: FYE Aug 31, 2022.

Nonqualified stock option (NQSO): the tax result at grant, at exercise, and at sale.

Grant: no income when the option has no readily ascertainable value (typical; strike at or above market). • Exercise: the bargain element (FMV − strike) × shares is ordinary compensation income (income and payroll tax). Basis = cash paid + income recognized = FMV at exercise. • Sale: sale price − FMV at exercise = capital gain or loss. The employer deducts the bargain element in the exercise year.

Practice problem: Gogo grants Mwana a nonqualified option to buy 10,000 shares at $8 for five years; the stock trades at $7.87 at grant. Income this year?

$0. The strike price is above the market price, so the option has no readily ascertainable value and nothing is taxed at grant. Income waits for exercise (the bargain element then).

Practice problem: 2021: BT grants Pieter a nonqualified option on 180 shares at $46 (stock at $44.52). 2026: he exercises at $57.90. (a) Income in 2021 and 2026? (b) Basis in the 180 shares?

(a) 2021: $0. 2026: (57.90 − 46) × 180 = $2,142 of ordinary income. (b) Basis = cash 180 × 46 = 8,280 + income 2,142 = $10,422 (= 180 × $57.90).

Incentive stock option (ISO): the tax result at exercise and sale, and the catch.

Grant: NQSO = No tax / ISO = No tax. Vesting: NQSO = No tax / ISO = No tax. Exercise: NQSO = Bargain element (FMV − strike) = ordinary income, basis = FMV / ISO = No regular tax, bargain element is an AMT preference, basis = strike. Sale: NQSO = Sale price − FMV at exercise = capital gain / ISO = Sale price − strike = capital gain. Employer: NQSO = Deducts the bargain element / ISO = No deduction. ISO: no regular income at exercise; basis = the strike price paid; on sale the whole spread (sale − strike) is capital gain. Dual advantage: deferral (tax waits for the sale) and conversion (ordinary income becomes capital gain). The catch: the untaxed bargain element is an AMT preference in the exercise year, and the employer gets no deduction.

Practice problem: 2021: BB grants Raul an ISO on 9,000 shares at $9.00 (stock at $8.79). 2026: he exercises at $26.37. (a) Income in 2021 and 2026? (b) Basis?

(a) 2021: $0. 2026: $0 of regular income. The bargain element (26.37 − 9.00) × 9,000 = $156,330 is an AMT preference, not regular income. (b) Basis = 9,000 × $9.00 = $81,000 (cash paid only).

How do you set up the NPV comparison of an NQSO vs. an ISO (exercise now, sell later)?

Year 0 (exercise): NQSO outflow = strike paid + ordinary tax on the bargain element. ISO outflow = strike paid only. Year of sale: proceeds − capital gains tax on (proceeds − basis). Basis is FMV at exercise for the NQSO, the strike for the ISO, so the ISO has the bigger gain. Discount the sale-year cash with the Appendix A factor (6%, 7 years = .665) and net. The ISO wins through deferral and conversion.

Practice problem: 2019: Jessee exercises an option, paying $100/share for 225 shares; market $312. 2026 (year 7): sells at $480. 35% ordinary rate, 15% capital gains, 6% discount rate. NPV of exercise-and-sale if (a) NQSO; (b) ISO?

(a) 2019: pays 22,500 plus tax 35% × bargain element 47,700 (225 × 212) = 16,695 → outflow 39,195. 2026: sale 108,000 − 15% × (108,000 − 70,200 basis) = 108,000 − 5,670 = 102,330 × .665 = 68,049. NPV $28,854. (b) 2019: outflow 22,500. 2026: 108,000 − 15% × (108,000 − 22,500) = 108,000 − 12,825 = 95,175 × .665 = 63,291. NPV $40,791.

Traditional 401(k): what happens to the elective deferral and the employer match in the tax formula?

Both are excluded from total income: taxable salary = salary − the employee's elective deferral; the employer's contribution is never in wages. Earnings inside the plan are untaxed. Every dollar comes out later as ordinary income. Contribution limits (reference sheet): $24,500 under 50; $32,500 at 50–59 and 64+; $35,750 at 60–63. Assume a plan is traditional unless told otherwise.

Practice problem: Ramesh's employer contributes 25 cents per dollar he contributes to its 401(k). He contributes the maximum allowable and earns $110,000. (a) Taxable salary? (b) Total contribution to his plan?

(a) Maximum elective deferral (under 50) $24,500. Taxable salary 110,000 − 24,500 = $85,500. (b) 24,500 + 25% × 24,500 = 24,500 + 6,125 = $30,625. The $6,125 match is also excluded from his income.

How much can someone contribute to an IRA, and does income ever stop a traditional contribution?

Lesser of the inflation-adjusted max ($7,500, plus a $1,100 catch-up at 50+, so $8,600) or earned income (the couple's combined earned income on a joint return). No age limit; deadline is April 15 of the following year. A traditional IRA contribution can be made at any AGI; income affects only whether it is deductible. A Roth contribution phases out on AGI ($242,000–$252,000 MFJ; $153,000–$168,000 single/HOH).

The traditional IRA deduction decision tree.

Not an active participant, spouse not either: Fully deductible at any AGI. Active participant: Phases out over $129,000–$149,000 MFJ, $81,000–$91,000 single/HOH. Not active, but spouse is (MFJ): Phases out over $242,000–$252,000. "Active participant" means in an employer plan (401(k), pension, SEP, etc.). The deduction is above the line. Inside a phase-out range, max deduction = limit × (1 − excess ÷ range); then deduct the lesser of the actual contribution or that max. The nondeductible remainder stays in the IRA as after-tax basis.

Zeke (60, active in his 401(k)) and Camilla (58, no earned income, not active) file jointly; AGI $141,000. He put $4,500 in his traditional IRA and $4,500 in hers. Deduction?

Zeke: phase-out 8,600 × (141,000 − 129,000) ÷ 20,000 = 5,160 → max deduction 3,440 → $3,440 deductible, $1,060 nondeductible. Camilla: nonparticipant with an active spouse, tested against $242,000; AGI is below it → full $4,500. Total above-the-line deduction $7,940 of $9,000 contributed.

Practice problem: Micah and Lin (MFJ) each contributed $7,500 to a traditional IRA. Deduction if (a) neither is an active participant, AGI $138,400; (b) Micah is active, Lin is not, AGI $158,400; (c) both are active, AGI $89,200?

(a) Nonparticipants deduct in full at any AGI: $15,000. • (b) Micah: active, AGI above $149,000 → $0. Lin: tested against $242,000 → full $7,500. Total $7,500. • (c) Both active but AGI below $129,000 → $15,000.

Practice problem: The Marlos (39 and 35, MFJ) each contributed $2,000 to a traditional IRA. Deduction if (a) he is active, she is not, AGI $134,000; (b) both active, AGI $73,000; (c) both active, AGI $218,500; (d) neither active, AGI $469,000?

(a) Mr.: max deduction 7,500 × (1 − 5,000 ÷ 20,000) = 5,625 > 2,000, so all $2,000. Ms.: AGI under $242,000, all $2,000. Total $4,000. • (b) AGI under $129,000 → $4,000. • (c) AGI over $149,000 → $0. • (d) Nonparticipants, any AGI → $4,000.

How much of a traditional IRA withdrawal is taxable?

If every contribution was deductible: 100% ordinary income. If some were nondeductible, a pro-rata share is a tax-free return of basis: nontaxable = withdrawal × unrecovered investment ÷ (year-end balance + current-year withdrawals). Unrecovered investment = nondeductible contributions not yet recovered; reduce it by each year's nontaxable amount. The rest is ordinary income.

Practice problem: Eloise (retired at 69) withdrew $35,000 in 2025 (year-end balance $441,000) and $60,000 in 2026 (year-end $407,000). Taxable amounts if (a) she made $320,000 of nondeductible contributions; (b) all contributions were deductible?

(a) 2025: ratio 320,000 ÷ (441,000 + 35,000) = 67.23%; nontaxable 35,000 × .6723 = 23,531; taxable $11,469. 2026: unrecovered 320,000 − 23,531 = 296,469; ratio ÷ (407,000 + 60,000) = 63.48%; nontaxable 38,088; taxable $21,912. (b) $35,000 and $60,000, all ordinary income.

After-tax cash from liquidating an IRA at retirement: Roth vs. traditional (all deductible) vs. traditional with nondeductible contributions.

Roth, qualified (59½ or older and 5 years since the first contribution): the whole balance, tax-free. • Traditional, all deductible: balance × (1 − marginal rate). • Traditional, partly nondeductible: the nondeductible contributions come back tax-free (unrecovered investment ÷ (0 + withdrawal) = 100% of them); tax applies to the rest. No 10% penalty once past 59½.

Practice problem: Levi, 64, will liquidate an IRA with $86,500 at a 24% marginal rate. After-tax cash if (a) it is a Roth opened in 2008; (b) a traditional IRA with all contributions deductible; (c) a traditional IRA with $20,400 deductible and $32,600 nondeductible contributions?

(a) Qualified Roth withdrawal: $86,500. • (b) 86,500 − 24% × 86,500 = 86,500 − 20,760 = $65,740. • (c) Taxable 86,500 − 32,600 = 53,900 × 24% = 12,936 → $73,564.

What is the guiding principle of §61, and what does the slide call the "good news"?

"Gross income means all income from whatever source derived." Everything is included in total income unless an exception tells you otherwise. The good news: the law provides many exceptions and special benefits for certain items; Week 3 is a tour of them (fringe benefits, retirement plans, option timing).

What counts as wage income, and what is the general rule for it?

Compensation from an employer for services: salary, hourly wages, bonuses, commissions, tips, overtime. General rule: all wages, cash and noncash, are taxable and go in total income. Special rule: eligible taxpayers may claim the other below-the-line deduction for tips and overtime, up to the caps.

Justin's $2,100 of premium overtime, but AGI $187,400. Deduction?

Excess AGI 37,400 → 37.4, which the slide rounds to 38 → 38 × $100 = 3,800 of phase-out, more than the $2,100 deduction. Deduction $0.

Gustav (single) earned $27,700 of qualified cash tips; AGI $204,000. Tips deduction?

Cap first: 25,000. Phase-out: (204,000 − 150,000) ÷ 1,000 = 54 × $100 = 5,400. Deduction 25,000 − 5,400 = $19,600.

What is a fringe benefit, and why does the policy note call the exclusion a big cost to the government?

Something of value an employee receives as compensation beyond regular cash wages: employer health insurance, free parking, tuition assistance, dependent care, a company car or plane for personal use, moving expenses. Big cost because the employer continues to deduct the cost while the employee pays no tax on it.

A Delta employee receives: family health insurance $6,000; parking $150/month; tuition reimbursement $4,000; on-premises daycare $5,000; standby flights to Hawaii $3,000; a $5,000 moving allowance; a company car used $2,000 personal / $4,000 work. Tax treatment of each?

Health insurance: excluded (no max) • Parking: excluded (below max) • Tuition: excluded (below max) • Daycare: excluded (below max) • Standby flights: excluded (no-additional-cost service, excess capacity) • Moving allowance: $5,000 included • Car: $2,000 personal use included; the work portion is not income

A private company gives an employee stock worth $20,000 in Year 1, restricted until Year 4. It is worth $250,000 in Year 4. Compare the general rule and the §83(b) election. Then suppose the company goes bankrupt and the stock is worth $0.

General rule: $250,000 of compensation in Year 4. §83(b): $20,000 in Year 1, nothing in Year 4. Bankruptcy: general rule, $0 taxed ever; §83(b), $20,000 taxed in Year 1 with no way to undo it. Trade-off: wait and pay tax later on whatever it is worth, or pay now while the value is (hopefully) low and accept forfeiture risk.

Define a stock option, the four dates, and the bargain element.

The right to buy the employer's stock at a stated exercise (strike) price for a limited time. No cash outlay by the employer; valuable because it may let the employee buy below market. Dates: grant (options allocated), vesting (can be exercised), exercise (stock bought at the strike), sale. Bargain element = price at exercise − strike: stock at $35 bought for $10 is a $25 bargain element.

Option to buy at $10; exercised at $35; sold at $75. Compare the NQSO and ISO results, and name the ISO benefits and downsides.

NQSO: $25 compensation at exercise, $40 capital gain at sale. ISO: nothing at exercise, $65 capital gain at sale. Both total $65. ISO benefits: no tax until the sale, and all of it is gain at preferential rates instead of compensation at ordinary rates. Downsides: less flexible (qualification rules), no deduction for the corporation, and the AMT preference at exercise.

Steve: 20,000 NQSOs at $3; vest at $13; exercised at $15; sold at $25. 35% ordinary, 15% capital gains. Tax in each year, and cash needed to exercise?

Grant and vesting: no tax. Exercise: (15 − 3) × 20,000 = 240,000 compensation × 35% = $84,000. Sale: (25 − 15) × 20,000 = 200,000 gain × 15% = $30,000. Total tax $114,000 on $440,000. Cash needed at exercise: 60,000 strike + 84,000 tax = $144,000.

Same facts as ISOs. Tax in each year?

Exercise: no regular tax; 240,000 bargain element is an AMT preference. Sale: (25 − 3) × 20,000 = 440,000 gain × 15% = $66,000. Total tax $66,000 vs. $114,000 for the NQSO, absent AMT.

Steve (single) has $78,000 of regular taxable income in the exercise year, took the standard deduction, and has the $240,000 ISO bargain element. AMT?

AMTI = 78,000 + 16,100 (standard deduction) + 240,000 = 334,100. Exemption 90,100 (no phase-out) → base 244,000 × 26% = TMT $63,440. Regular tax $11,872. AMT $51,568; total tax $63,440. The ISO bargain element isn't in regular taxable income, but it can trigger AMT in the exercise year.

What is a qualified employer retirement plan, and what are the two main types?

An investment plan that meets statutory requirements in exchange for favorable tax treatment: assets held by an independent trustee for the employee's exclusive benefit; nonforfeitable rights within a set period; offered to all employees equitably. Policy: broad-based retirement saving. Defined benefit (pension; employer promises benefits and bears the risk; not covered). Defined contribution (401(k), ESOP, profit-sharing; set contributions, employee controls investments and bears the risk). The class covers 401(k)s only.

Traditional 401(k): contributions, earnings, distributions, and the government's trade-off.

Employees elect to have the employer direct part of wages to the plan (elective deferral, annual limits); employers may add matching or nonelective contributions. Contributions and earnings are not taxed currently; distributions in retirement are taxed at ordinary rates. Government: a cost at contribution (tax not collected on salary), revenue at distribution (tax on the whole withdrawal).

Why do retirement plans have both an early-withdrawal penalty and required minimum distributions?

The policy wants people to save and not touch the money until retirement, but the government also wants its tax eventually. So: a penalty for withdrawing too soon (before 59½, many exceptions) and a penalty for withdrawing too late or too little (RMDs must begin by age 73).

Josie earns $96,000, contributes $10,000, and her employer matches up to 6% of salary. Total contribution and taxable salary? At 60 she withdraws $23,000 (25% rate); at 50 (30% rate)?

Contribution 10,000 + match 5,760 (6% × 96,000) = $15,760. Taxable salary 96,000 − 10,000 = $86,000. At 60: all $23,000 taxable × 25% = $5,750. At 50: tax 30% × 23,000 = 6,900 plus 10% penalty 2,300 = $9,200.

Roth 401(k) vs. traditional: what is the same and what is different? Josie's taxable salary under a Roth election?

Same: contribution limits, employer contributions allowed, earnings untaxed inside the plan. Different: contributions (including the employer match) are taxed now; qualifying distributions are tax-free; no RMDs; early withdrawals hit only a portion. No income limit, unlike a Roth IRA. Josie: 96,000 − 0 + 5,760 match = $101,760 taxable salary. Her $23,000 retirement distribution: $0 tax.

What rules apply equally to traditional and Roth IRAs?

Annual contribution up to the lesser of the inflation-adjusted max or earned income (plus spouse's if MFJ) • Catch-up contributions by age • Deadline: April 15 of the following year • No age limit on contributing • Earnings are not taxed while inside the IRA The owner sets up the account at a financial institution (the trustee) and controls the investments.

The three differences between a traditional and a Roth IRA.

Contributions: traditional may be deductible (pre-tax dollars); Roth never (after-tax dollars). • Distributions: traditional qualifying distributions are ordinary income; Roth qualifying distributions are tax-free. • RMDs: required for traditional; not for Roth.

The active-participant phase-out for traditional IRAs limits what, exactly?

The ability to deduct the contribution, not the ability to make it. Anyone with earned income can contribute to a traditional IRA at any AGI; the nondeductible part becomes after-tax basis recovered tax-free on withdrawal.

James (40, single) has $522,000 of earned income and AGI $519,000; not in an employer plan. Traditional IRA contribution and deduction? Roth? What if he were in an employer plan?

Traditional: contribute the lesser of earned income or $7,500 = $7,500, fully deductible (nonparticipant). Roth: none, AGI is above the phase-out. If he were an active participant: he can still contribute $7,500 but it is nondeductible (AGI above $91,000), and the Roth is still closed.

Same Zeke and Camilla facts, but the $4,500 contributions go to Roth IRAs. Deduction?

None. Roth contributions are never deductible, regardless of participation or AGI.

Over 20 years someone contributed $100,000 to a traditional IRA, $30,000 of it nondeductible. First withdrawal $10,000; year-end balance $230,000. Taxable?

Nontaxable = 10,000 × 30,000 ÷ (230,000 + 10,000) = $1,250. Taxable $8,750. Unrecovered investment afterward: 28,750.

Elaine (63) withdraws $27,000; year-end balance $358,000. Taxable if her $102,500 of contributions were all deductible? If $38,500 were nondeductible? Tax at a 25% rate, and if she were under 59½?

All deductible: $27,000 taxable. With $38,500 nondeductible: nontaxable 27,000 × 38,500 ÷ 385,000 = 2,700; taxable $24,300; unrecovered investment afterward $35,800. Tax 24,300 × 25% = $6,075. Under 59½: 24,300 × (25% + 10%) = $8,505.

When is a Roth IRA distribution "qualified," and what are the ordering rules for a nonqualified one?

Qualified (never taxable) if both: the account was opened and first funded more than five years ago, and the owner is at least 59½ (exceptions exist). Nonqualified: distributions come from contributions first (tax-free, penalty-free), then earnings (ordinary income, plus the 10% penalty on that taxable portion if under 59½). No RMDs, so no too-late penalty.

Sampson (57) has contributed $111,000 to his Roth IRA over 20 years; balance $142,000. Year 1: first distribution $98,000 (43% rate). Year 2 (age 58, balance $48,900): another $20,000 (32% rate). Tax and penalty each year?

Both are nonqualified (under 59½), but ordering rules apply. Year 1: 98,000 is less than 111,000 of contributions → 100% nontaxable, no penalty. Year 2: 111,000 − 98,000 = 13,000 of contributions left → 13,000 tax-free; the remaining 7,000 is earnings × (32% + 10%) = $2,940 tax and penalty.

Can a high-income taxpayer contribute to a Roth IRA, and how do Roth contributions and distributions show up in the four-step formula?

Individuals with AGI above the inflation-adjusted threshold cannot make direct Roth contributions. Contributions are not deductible anywhere in the formula; qualifying distributions (and the contribution portion of nonqualifying ones) are excluded from total income.

Eligibility, reporting, and purpose of the tips/overtime deduction (the book's details).

Eligibility: tips must be in an occupation on Treasury's list of jobs that customarily received tips, and must be voluntary and reported; overtime must meet the federal labor-law definition of time-and-a-half. Reporting: an "Additional Deduction" on Schedule 1-A, alongside the senior deduction and car loan interest; employers must separately track and report tips and overtime on the W-2. Purpose: boost take-home pay for low- and middle-income service and hourly workers. Still subject to payroll tax.

Elle Mac (single): $32,500 of qualified tips, AGI $161,500. The Rowes (joint): overtime premium $4,000 + $6,000, AGI $360,000. Deductions?

Elle: cap 25,000; excess 11,500 → 11.5 rounds down to 11 × $100 = 1,100 → $23,900. Rowes: 10,000 premium (under the $25,000 joint cap); phase-out (360,000 − 300,000) ÷ 1,000 × $100 = 6,000 → $4,000.

Employer-provided health coverage: what is excluded, and how big is the tax expenditure?

Employees exclude the value of employer-provided health and accident coverage; premiums the employer pays directly to insurers aren't taxable; participants in self-insured medical reimbursement plans don't recognize the imputed value of coverage. It is the largest item in the tax expenditures budget, over $220 billion a year.

Group term life insurance: how much is excluded, and how is the excess measured? Mr. Kung, 46, has $200,000 of coverage.

Excluded only up to $50,000 of coverage. Above that, the employee is taxed on the cost of the excess using Treasury's uniform premium table, not the employer's actual premium. Kung: 150 (thousands over $50,000) × $0.15 × 12 months = $270 on his W-2.

Do fringe-benefit exclusions extend to the self-employed, partners, and S corporation shareholders? What is the one exception?

No. Benefits the self-employed provide for themselves are paid with after-tax dollars (a $750 premium on a $50,000 life policy is a nondeductible personal expense). A partner's group term life cost is a taxable guaranteed payment; an S corp shareholder-employee's is taxable compensation. Exception: medical and accident insurance for themselves and family is an above-the-line deduction. Vernon LLC's George includes $2,650 and deducts $2,650: net AGI effect $0.

Why can substituting nontaxable fringe benefits for salary make both employer and employee better off? Leyton Corp. (21%) and Ms. King (35%).

Option 1: $200,000 salary costs Leyton $168,916 after tax and is worth $116,182 to King. Option 2: $185,000 salary plus benefits worth $12,000 to King that cost Leyton $9,000: Leyton's cost drops to $164,005 ($4,911 less) and King's value rises to $118,649 ($2,467 more). Why: the benefit is deductible to the employer, not taxable or payroll-taxed to the employee, and costs the employer less than it is worth to the employee, so the employer captures part of the employee's tax saving.

Why do corporations pay key employees with stock and options?

Employees become stakeholders with a direct incentive to drive long-term success. For the employer there is no cash outlay, and options can even bring in capital when exercised (the strike price is paid-in capital).

Drew receives 4,000 restricted shares on June 30, 2022 (FMV $29,000), restricted until July 1, 2026, when they are worth $45,500. Income, basis, and what happens when he sells some shares to pay the tax?

2022: no income (nontransferable and at risk of forfeiture). July 1, 2026: $45,500 of ordinary income, subject to income and payroll tax; basis $45,500. Selling shares at FMV to pay the tax creates no additional income because sale price equals basis. Deferral cut against him: with a §83(b) election he would have been taxed on $29,000 in 2022 and nothing in 2026 (but would have had no deduction had he forfeited).

Liam: option on 2,000 shares at $30 (market $28 at grant), exercised in Year 8 at $75. Income, basis, cash flow, and BRT's side?

Grant: no income (strike above market). Exercise: cash paid 60,000; FMV 150,000; bargain element $90,000 ordinary income; basis $150,000. Year 8 cash flow is negative: $60,000 plus income and payroll tax on $90,000; he can sell shares to cover it with no extra income unless the price exceeds $75. BRT books $60,000 of paid-in capital and deducts $90,000.

Liam sells the shares in Year 15 for $225,000. Compare total tax if the option was an ISO vs. nonqualified (37% ordinary, 20% capital gain). What is the employer's side?

ISO: Year 8 $0; Year 15 gain 225,000 − 60,000 = 165,000 × 20% = $33,000 total. Nonqualified: Year 8 33,300 (90,000 × 37%); Year 15 gain 75,000 × 20% = 15,000; $48,300 total. Employer: never deducts an ISO's bargain element (a permanent book/tax difference). BRT's Year 8 cash: $60,000 (ISO) vs. $78,900 (nonqualified, including the $18,900 tax saving).

What is the AMT caution for ISOs? Maya Craig.

The untaxed bargain element is an AMT adjustment added to taxable income in computing AMTI, so avoid exercising ISOs in a year with AMT exposure. Maya Craig's exercise raised AMTI from $625,000 to $1,010,000 and produced $70,353 of AMT.

When must RMDs begin, how are they set, and what is Ms. Ramone's first RMD?

No later than April 1 of the year after the participant turns 73 (75 if born after 1959). The entire interest must be distributed over the life expectancy of the participant and the designated beneficiary, using Treasury life expectancy tables. Roth accounts have no RMDs. Ramone (73 in 2026): first RMD by April 1, 2027; 26.5-year period → 3.77% × $319,200 = $12,034 taxable.

The 10% penalty: when it applies, the three exceptions, and the rollover escape. Jung Soo and Harrison.

A 10% penalty on a withdrawal from a traditional qualified plan before age 59½, applied only to the portion included in income. Waived if the owner is totally and permanently disabled, has reached 55 and terminated employment with the sponsor, or the withdrawal is by the estate or beneficiary after death. Jung Soo at 51: $16,000 income plus $1,600 penalty; at 63, income only. Rolling over to another plan or IRA within 60 days avoids both: Harrison (48) rolled $23,000 of a $35,000 distribution and kept $12,000 → 24% tax $2,880 + penalty $1,200 = $4,080.

Who can save in an IRA, and what is the one-word difference between a traditional and a Roth IRA's earnings?

Anyone with employee compensation or self-employment income. IRAs are tax-exempt, so earnings grow at a before-tax rate. Traditional: withdrawals are ordinary income, so earnings are tax-deferred. Roth: withdrawals are nontaxable, so earnings are tax-exempt.

Max 2026 IRA contribution: Shannon (19, $3,725 of SE income); Lynn (25, $22,050 wages); Laurant and Chris (36 and 37, MFJ, $47,200 + $4,180); Ali (64, $41,950 SE income)?

Shannon: $3,725 (limited to earned income) • Lynn: $7,500 • Laurant and Chris: $7,500 each; combined compensation exceeds $15,000, so the low earner can fund a full IRA • Ali: $8,600 (7,500 + 1,100 catch-up)

Tom Tran (40, single, AGI $159,670). Max Roth contribution, and what can he do with the rest?

Excess AGI 159,670 − 153,000 = 6,670 ÷ 15,000 = 44.5% phase-out × 7,500 = 3,338 → max Roth $4,162. He can put the other $3,338 in a traditional IRA for $7,500 total. (Traditional contributions have no income limit; Roth contributions do.)

Rian and Tessa Howard (MFJ, both active participants) each contributed $7,500; AGI before the deduction $138,700. Deduction each, and AGI after? What if they had contributed $2,500 each?

Excess 9,700 ÷ 20,000 = 48.5% × 7,500 = 3,638 phase-out → $3,862 each, $7,724 total → AGI $130,976. (The notes flag that the textbook's own AGI figures don't tie out; the $3,862 deduction is the number to trust.) Reported on Schedule 1, line 20. At $2,500 each, the contribution is under the $3,862 max, so it is fully deductible: AGI $133,700.

Nonparticipants: the general rule and the spouse exception. The Dowds (both 60, $8,600 each; Mr. active, Ms. not) at AGI $83,800, $173,700, and $256,600?

General rule: a nonparticipant deducts in full regardless of AGI (Ari Radick: 364,600 − 7,500 = $357,100). Exception: a nonparticipant filing jointly with an active-participant spouse phases out over $242,000–$252,000. • $83,800: both fully deductible → AGI $66,600 • $173,700: Mr. nondeductible (above $149,000), Ms. fully deductible → $165,100 • $256,600: both nondeductible → $256,600

The one rule for Roth IRA contributions.

They are never deductible, so a Roth consists only of after-tax dollars, regardless of AGI or active-participant status (the Bartletts' $4,000). The payoff is tax-free qualified withdrawals.

Helmie contributed $44,000 to a traditional IRA, $19,000 nondeductible. 2025: withdrew $15,000, year-end balance $73,220. 2026: withdrew $17,500, year-end $60,200. Ordinary income each year?

2025: ratio 19,000 ÷ 88,220 = .2154; nontaxable 3,231; income $11,769. 2026: unrecovered 15,769 ÷ 77,700 = .2029; nontaxable 3,551; income $13,949. By the time the account is empty, all $19,000 has come back tax-free.

Two IRA-specific rules on withdrawals: when they must start, and which early withdrawals escape the 10% penalty.

Withdrawals must begin by April 1 of the year after reaching 73 and follow the RMD each year. Before 59½ the 10% penalty applies, but it is waived for higher-education expenses (tuition, fees, books, supplies, equipment) and first-time homebuyers up to $10,000. The taxable portion is still taxable; it just escapes the penalty.

Alex withdraws $14,000 from a Roth IRA first funded in 2006. Result if over 59½? If under?

Over 59½ and past the five-year period: a qualified withdrawal, entirely tax-exempt; earnings are never taxed. Under 59½: not qualified, so the earnings portion is taxable plus the 10% penalty on that portion. Roth owners never face RMDs and can let the account grow until death.