Income Tax Planning
Marginal Versus Effective Rates
Tax planning hinges on the marginal rate, the rate on the next dollar of income, versus the effective rate, total tax divided by total income. Decisions such as Roth conversions, deductible contributions, and capital gain timing depend on marginal rates. Know the treatment of ordinary income, long-term capital gains and qualified dividends (preferential rates), and the distinction between above-the-line deductions and itemized deductions.
Timing, Character, and Jurisdiction
Three levers drive tax planning: timing (defer income, accelerate deductions), character (convert ordinary income into capital gains or tax-free income), and jurisdiction (state taxes, residency). Understand basis, realized versus recognized gain, and the role of losses in offsetting gains. Know that retirement contributions may be pre-tax or after-tax, and that distributions carry different tax treatment.
Traps in Exam Questions
A frequent trap is assuming a higher income always pushes all income into a higher bracket; only the marginal dollars are taxed at the higher rate. Another trap confuses a deduction (reduces taxable income) with a credit (reduces tax dollar for dollar). Watch for questions about the step-up in basis at death and about wash sale rules on loss harvesting. Also watch for state tax differences being ignored in relocation questions.
Worked Example
A client in the 24% marginal bracket contributes $7,000 to a deductible retirement account. The immediate tax savings are $1,680. If the client instead expects a 12% bracket in retirement, the deferral is favorable: tax is paid later at a lower rate. But if the client expects a 32% bracket later, a Roth contribution may be superior. The planner compares marginal rates now versus expected marginal rates at distribution.
Rule of Thumb
Compare marginal rate now to expected marginal rate at withdrawal; defer when the future rate is lower.