Tax Planning
Domain 5 tests the application of tax rules to planning decisions: marginal versus average rates, deductions versus credits, deferral, and timing. The exam expects the method, not just the final figure.
Core concepts
- Marginal rate applies to the next unit of income; average rate is total tax divided by taxable income.
- A deduction reduces taxable income; a credit reduces tax payable. A credit is usually worth more per unit to a low-income taxpayer; a deduction is worth more to a high-rate taxpayer.
- Tax deferral keeps money invested before tax; it is valuable when the future rate is lower or the horizon is long.
- Capital gains, dividends, and interest may be taxed differently. Holding period and account type matter.
- Income splitting and timing shift income to lower-rate years or taxpayers, subject to anti-avoidance rules.
- Tax avoidance uses the law; tax evasion involves concealment or false reporting and is illegal.
Worked example
Assume taxable income is 750,000. The scale is 10% on the first 300,000, 20% on the next 300,000, and 30% above 600,000. Tax = 30,000 + 60,000 + 45,000 = 135,000. The average rate is 135,000 / 750,000 = 18%; the marginal rate is 30%. An additional 100,000 of income is taxed at 30,000, so the couple keeps 70,000. A deduction of 100,000 would save 30,000; a credit of 100,000 would reduce tax by 100,000. If the client can defer 100,000 to a year when the marginal rate is 20%, the deferral saves 10,000 in tax, before considering investment growth.
Traps
- Reporting the average rate as the marginal rate, or vice versa.
- Treating a credit as a deduction.
- Ignoring phase-outs and thresholds that raise the effective marginal rate.
- Forgetting that deferral is not exemption; the tax is still paid later.
- Overlooking tax on withdrawals from retirement accounts.
- Recommending a transaction with no business purpose solely for tax benefit.