Tax Planning Fundamentals
Domain overview
Tax planning fundamentals tests marginal versus effective rates, deductions versus credits, timing strategies, and tax-advantaged accounts. Expect calculation questions and questions on which account or action is tax-efficient for a given goal.
Core rules
A progressive tax system applies higher rates to higher slices of income. The marginal rate applies to the next dollar; the effective or average rate is total tax divided by taxable income. A deduction reduces taxable income, so its value equals the deduction times the marginal rate. A credit reduces tax directly, dollar for dollar. Capital gains and dividends may receive different treatment from ordinary income.
Planning levers
Common levers include deferral, income shifting, tax-loss harvesting, asset location, and charitable giving. Tax deferral is valuable when the future rate is lower or the funds grow for a long time. Compare after-tax outcomes, not just pre-tax balances.
Worked example
Taxable income is $80,000 and tax is $10,000, so the average rate is 12.5%. The client is in the 22% marginal bracket. A $5,000 deduction saves $5,000 × 22% = $1,100. A $1,100 tax credit saves $1,100. The deduction is worth less than its face amount; the credit is worth its full face amount. If the client instead contributes to a tax-deferred account, the benefit depends on the future withdrawal rate. The reasoning prevents the common error of valuing a deduction at the average rate.
Traps that cost marks
- Treating a deduction as a dollar-for-dollar tax reduction.
- Using the marginal rate to describe total tax.
- Ignoring phase-outs, surtaxes, and state taxes.
- Comparing pre-tax balances without adjusting for taxes.