Tax Planning Fundamentals
Tax Planning Fundamentals
This domain tests the mechanics of the tax system well enough to choose between vehicles and timing strategies - not to prepare a return.
Core concepts
- The marginal rate applies to the next dollar; the average (effective) rate is total tax ÷ total income. Every planning decision is made at the margin.
- A deduction reduces taxable income and is worth the marginal rate. A credit reduces tax payable directly and is worth its face amount. At a 30% marginal rate a $5,000 deduction saves $1,500; a $5,000 credit at 20% saves $1,000.
- Deferral: tax-deferred accounts give a deduction now and tax later; tax-free accounts give no deduction but tax-free growth and withdrawals. Deferral's advantage depends on the rate in versus the rate out.
- Capital gains are typically taxed at a fraction of the ordinary rate; losses offset gains, and unused losses carry forward. Harvesting losses in a down year is cheap, subject to superficial-loss or wash-sale rules.
- Income splitting shifts income to a lower-rate family member, subject to attribution rules that reverse transfers to a spouse or minor child.
- Progressive brackets create planning windows: accelerate income into a low-income year, or delay deductions into a high-rate year.
Worked example
A client earning $120,000 at a 32% marginal rate can contribute $10,000 to a tax-deferred or a tax-free plan. Deferred: saves $3,200 now; if withdrawn at 24%, tax is $2,400, so the net benefit is $800 plus growth on the pre-tax amount. Tax-free: no deduction, but $10,000 of after-tax money grows and is withdrawn tax-free. If the client expects a lower rate in retirement, deferral wins; if the rates are equal, the two are mathematically equivalent - a point many candidates miss.
Traps that cost marks
- Treating a deduction and a credit of equal dollar value as equivalent.
- Ignoring clawbacks of income-tested benefits, which push the effective marginal rate above the stated bracket.
- Overlooking withholding tax on withdrawals and estimated-instalment obligations.
- Applying wash-sale or superficial-loss rules only to the identical security and not to substantially identical replacements.
- Assuming deferral always wins without comparing entry and exit rates.