For the following questions, assume you face a 20 percent tax on ordinary income

Question

For the following questions, assume you face a 20 percent tax on ordinary income, but capital gains are taxed at a separate low rate of 10 percent. (Ignore phaseouts.)

a.) You buy a stock for $1000 in year 1. Its value rises to $1200 in year 2, and then you sell it for $1300 in year 3. (The stock pays no dividends.) Under U.S. tax rules, how do the stock trades change your tax payments in each of the three years? (Give numbers.)

b.) Under a genuine income tax how would the stock trades change your tax payments in each year? Explain the difference between your answers in (a) and (b).

c.) Suppose instead that your employer contributes $1000 to your company pension plan. Under U.S. tax rules, how does the contribution change your tax payments in year 1? Describe the rule you are using.

d.) After your employer contributes the $1000 to your pension plan in year 1, the value of this contribution again rises to $1200 in year 2, and then $1300 in year 3. You then withdraw the entire $1300. Under U.S. tax rules, how does the withdrawal change your tax payments in year 3? (Ignore penalties for early withdrawals.)

e.) If you had instead contributed the $1000 to a tradional IRA, and then withdrawn the $1300 in year 3, how would your tax payments change in years 1, 2, and 3?

f.) How would your answer to (e) change for a traditional IRA.  

Explanation / Answer

Ans a – As the stock was held for more than one year the gain derived is a long term capital gain. In year 1 and year 2 there is not tax change, however, in the year 3 when the stock is sold, capital gain arises and that is of $300 which is fully taxable at 10%.

Ans b – Under the genuine income tax the rise in the value of the stock will be taxed irrespective of the assets being transferred.

Ans c – In the first and the second year the amount contributed is not treated as an income at all, hence there is no effect on tax. The retirement plans rule of employer provided plans have been used.

Ans d – In the year 3, the whole amount of $1300 received will be taxed.

Ans e – There will be no change in the first and the second year, however, the withdrawal of $1300 in the year 3 will be completely tax free.

Ans f – If the amount had been contributed to a traditional IRA, then even the contribution of $1000 made in the first year can be claimed as deduction for the first year and the $1300 received in the third year will be ta free.

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