Tax Planning
This domain tests marginal versus average tax rates, deductions versus credits, capital gains, tax-advantaged accounts, timing, income splitting, and the line between avoidance and evasion. Questions often ask which action saves more tax, when to defer income, and how account location affects after-tax wealth.
Core rules and concepts
- The marginal rate applies to the next dollar of taxable income; the average rate is total tax divided by taxable income. A deduction's value equals the deduction times the marginal rate. A credit reduces tax dollar-for-dollar and is usually worth more.
- Tax deferral lets earnings compound before tax. It is advantageous if the future tax rate is lower, if the deferral period is long, or if the account avoids annual tax drag.
- Capital gains are taxed on realization. Long-term gains often receive preferential rates; losses can offset gains and limited ordinary income, subject to wash-sale rules.
- Tax-advantaged accounts have contribution limits, eligibility rules, penalties, and required distributions. Account location should place tax-inefficient assets in tax-deferred accounts where possible.
- Timing strategies include bunching deductions, accelerating deductions, deferring income, and harvesting gains or losses. Income splitting shifts income to lower-bracket family members, subject to anti-avoidance rules.
- Tax avoidance is legal planning; tax evasion is illegal concealment. Documentation and substance matter.
Worked example
A taxpayer in the 24% marginal bracket can choose a 10,000 deduction or a 10,000 credit. The deduction saves 10,000 x 0.24 = 2,400. The credit saves 10,000, assuming tax liability is at least that amount. Reasoning: the credit is worth 7,600 more. If the choice were between a deductible account and a Roth account, the comparison would be the current tax saving versus tax-free future withdrawals: a deductible contribution is better if the future rate is lower, while a Roth is better if the future rate is higher.
Traps that cost marks
- Treating a deduction as if it were a credit.
- Using the average rate to value the next deduction.
- Ignoring state and local taxes.
- Forgetting wash-sale rules after a loss harvest.
- Overlooking phaseouts and contribution limits.
- Confusing legal avoidance with illegal evasion.