Individual Income Tax

Income tax fundamentals are tested frequently on the Series 65 exam. You need to know how different types of income are taxed, how cost basis works, how brackets apply, and how distributions and government benefits interact with income levels.

How Are Capital Gains Taxed?

Capital gains are profits from selling an asset for more than its cost basis. The tax rate depends on how long you held the asset.

Short-Term vs. Long-Term: What's the Difference?

• Short-term: held 1 year or less - taxed at ordinary income rates (up to 37%)
• Long-term: held more than 1 year (1 year + 1 day) - taxed at preferential rates: 0%, 15%, or 20% depending on taxable income

When Does the Holding Period Start and Stop?

• For securities traded on an established market, the holding period begins the day after the trade date of the purchase and ends on the trade date of the sale
• Use the trade date, not the settlement date, at both ends
• Because counting starts the day after, the first day that qualifies as long-term is one year and one day after the purchase

Exam Tip: Gotchas

• Buy on January 14, sell on January 15 of the next year, and the gain is still SHORT-term. Counting starts January 15 of the purchase year, so January 15 of the following year is exactly one year, not more than one year. Selling on January 16 is the first long-term day.

What Is the Net Investment Income Tax (NIIT)?

• An additional 3.8% surtax on investment income (capital gains, dividends, interest, rental income)
• Applies to individuals with modified adjusted gross income (MAGI) above $200,000 (single) or $250,000 (married filing jointly)
• Stacks on top of regular capital gains rates: a high-income taxpayer in the 20% long-term capital gains (LTCG) bracket effectively pays 23.8% on long-term gains

How Do Net Capital Loss Rules Work?

• Capital losses offset capital gains dollar-for-dollar (no limit)
• After offsetting gains, up to $3,000/year of remaining net loss can be deducted against ordinary income ($1,500 if married filing separately)
• Unused losses carry forward indefinitely; each year they first offset gains, then up to $3,000 against ordinary income

Exam Tip: Gotchas

• The $3,000 annual deduction limit applies only to net capital losses against ordinary income. There is no limit on using capital losses to offset capital gains.

What Is the Wash Sale Rule?

• Selling a security at a loss and purchasing a substantially identical security within 30 days before or after the sale means the loss is disallowed
• The disallowed loss is added to the cost basis of the replacement security (deferred, not permanently lost)
• The full blackout window spans 61 days total: 30 days before the sale, the sale date itself, and 30 days after
• Acquiring a contract or option to buy the substantially identical security counts as a repurchase and triggers the rule

Which Accounts Does the Wash Sale Rule Reach?

• The rule looks at all of the taxpayer's accounts together, not just the account that held the loss
• A repurchase in the taxpayer's IRA or Roth IRA triggers it, and so does a purchase by the taxpayer's spouse or by a corporation the taxpayer controls
• Selling at a loss in a taxable account and buying back in a retirement account is the classic tax-loss-harvesting trap

Exam Tip: Gotchas

• The disallowed loss is not permanently lost. It gets added to the replacement security's basis, deferring the tax benefit.
• The IRA repurchase is the one exception, and it is the harshest one. When the replacement shares are bought inside an IRA or Roth IRA, the disallowed loss is not added to the IRA's basis. That loss is gone for good rather than deferred.

How Are Qualified Dividends Taxed?

Not all dividends receive the same tax treatment. Qualified dividends are taxed at the same preferential rates as long-term capital gains. Non-qualified (ordinary) dividends are taxed at ordinary income rates.

What Are the Requirements for Qualified Treatment?

1. Paid by a U.S. corporation or a qualified foreign corporation
2. Holding period: stockholder must hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date

What Tax Rates Apply?

Same as long-term capital gains: 0%, 15%, or 20%

Which Dividends Are NOT Qualified?

These are taxed as ordinary income:

• REIT dividends - ordinary income (not qualified dividends)
• Master limited partnership (MLP) distributions - often return of capital, reducing basis rather than being immediately taxable; MLPs use K-1 reporting
• Money market fund distributions - not equity, so not dividends
• Dividends where the holding period is not met

Exam Tip: Gotchas

• REIT dividends are ordinary income, not qualified dividends, even though REITs are corporation-like entities. This is one of the most frequently tested points in this topic.

How Does Tax Basis Work?

Tax basis determines your gain or loss when you sell an asset. The correct basis is the foundation of every capital gains calculation.

What Is Cost Basis?

• Purchase price + commissions/fees = cost basis
• Stock splits - basis per share is adjusted proportionally (total basis unchanged)
• Stock dividends - basis per share is adjusted proportionally (total basis unchanged)

What Events Adjust Basis After Purchase?

Basis is not frozen at the purchase price. Some events push it down, others push it up.

• Return-of-capital distributions reduce basis (the investor is getting their own money back, so it is not taxed now)
• Depreciation deductions on rental or business property reduce basis
• A deducted casualty loss on property reduces basis
• Reinvested dividends increase basis (the investor already paid tax on the dividend and used it to buy more shares)

Exam Tip: Gotchas

• Reinvested dividends are the one that moves basis UP. Return of capital, depreciation, and casualty losses all move it down. Forgetting to add reinvested dividends is the most common way an investor overstates their gain and overpays.

How Is Basis Identified When Only Part of a Position Is Sold?

When shares of the same security were bought at different times and prices, the method used to pick which shares were sold changes the reported gain.

• FIFO (first in, first out) is the default. If the investor does not identify the lot, the sale is charged against the earliest shares bought. Those are usually the lowest-basis shares, so FIFO typically produces the largest taxable gain
• Specific identification lets the investor name which lot is sold, telling the broker at or before the sale. This gives the most flexibility for tax planning, such as selling the highest-basis lot to minimize a gain
• Average cost blends all shares into one per-share basis. It is available only for mutual fund shares and dividend reinvestment plan shares, never for a directly held stock position
• An investor may switch from average cost to another method going forward by notifying the broker in writing. No IRS permission is needed, and the change applies only to future sales

Exam Tip: Gotchas

• FIFO is a default, not a requirement. It applies only when the investor fails to identify the lot. An investor who wants a different result must specify the lot at or before the sale, not after seeing the tax bill.

How Does Stepped-Up Basis Work at Death?

• Inherited assets receive a new cost basis that resets to fair market value (FMV) at date of death: a step-up if the asset appreciated, or a step-down if it depreciated
• For an appreciated asset, this eliminates the embedded capital gain that built up during the decedent's lifetime
• Holding period is automatically long-term regardless of how long the decedent held the asset

How Does Carryover Basis Work for Gifts?

• Recipient takes the donor's original cost basis, NOT the FMV at time of gift
• Exception: if FMV at time of gift is lower than donor's basis (the asset lost value before the gift) and the recipient sells at a loss, the recipient uses the FMV at date of gift as basis, not the donor's original basis
• The recipient also takes the donor's holding period. A gift of stock the donor had held for three years is long-term in the recipient's hands from day one

Inherited vs. Gifted: How Do the Bases Compare?

Think of it this way: Inheritance resets the tax meter to zero. Gifting passes the old meter reading along. A stock bought at $10 and now worth $100 has $90 in embedded gains. Inherit it and the basis becomes $100 (no taxable gain). Receive it as a gift and the basis stays at $10 (you owe tax on the $90 gain when you sell).

Memory Aid: Death = Delete the gain (basis resets to FMV: step-up or step-down). Gift = Grandfather the basis (carryover).

Exam Tip: Gotchas

• Inherited = basis resets to FMV (step-up or step-down). Gifted = carryover of donor's basis. These produce opposite outcomes and are commonly tested together.
• If a question asks about eliminating an embedded capital gain on an appreciated asset, the answer involves inheritance, not gifting.

How Does the Marginal Tax Bracket Work?

The U.S. uses a progressive tax system where higher income is taxed at higher rates. Many clients (and exam questions) confuse marginal and effective rates.

What Do Marginal and Effective Rate Mean?

• Progressive tax system: Higher income taxed at higher rates; lower income taxed at lower rates within each bracket
• Marginal rate: Rate applied to the last (highest) dollar of income - the bracket rate
• Effective rate: Total taxes paid / total taxable income; always lower than the marginal rate because lower income is taxed at lower brackets

Think of it this way: Your income fills up each bracket like water filling stacked buckets. The first bucket (10%) fills up first, then spills into the next (12%), and so on. Only the water in the top bucket gets taxed at the highest rate.

What Are the 2026 Federal Brackets?

The seven ordinary income rates are: 10%, 12%, 22%, 24%, 32%, 35%, 37%

• Bracket widths vary by filing status. Married filing jointly has the widest brackets, so the same income is taxed the least. Head of household is wider than single in the lower brackets. Married filing separately is not a middle ground. Its thresholds are identical to single's all the way through the 35% bracket, then it reaches the top 37% rate at a far lower income than single does. Married filing separately is generally the least favorable status, not an in-between one.
• Tax-advantaged investments (municipal bonds, retirement accounts) are most valuable to investors in higher marginal brackets

Exam Tip: Gotchas

• A client in the 32% bracket does NOT pay 32% on all income. Only income within that bracket is taxed at 32%. The effective rate is always lower than the marginal rate.

What Is the Alternative Minimum Tax (AMT)?

The AMT is a parallel tax calculation that ensures high-income earners with large deductions still pay a minimum amount of tax.

How Is AMT Calculated?

1. Start with regular taxable income
2. Add back certain tax preference items and adjustments to arrive at Alternative Minimum Taxable Income (AMTI)
3. Subtract the AMT exemption (phases out at higher income levels)
4. Apply AMT rates: 26% and 28% (28% applies to AMTI above $244,500 for most filers, $122,250 for married filing separately)
5. Taxpayer pays the greater of regular tax or AMT

Think of it this way: You calculate taxes two ways (regular and AMT) and pay whichever amount is higher. The AMT acts as a floor: if your regular tax dips too low due to deductions and exclusions, the AMT catches the difference.

What Commonly Triggers AMT?

• Incentive stock option (ISO) exercises - the spread between FMV and exercise price is added to AMTI
• Private activity municipal bond interest - tax-exempt for regular income tax but included in AMTI
• State and local tax deductions

Exam Tip: Gotchas

• Private activity municipal bond interest is tax-exempt for regular income tax but included in the AMT calculation. If a question asks about tax-exempt bonds that trigger AMT, the answer is private activity bonds.
• Exercising ISOs without selling in the same year triggers AMT. The spread (fair market value minus exercise price) is added to AMTI.

When Must Retirement Plan Distributions Begin?

What Are the RMD Rules?

• RMDs must begin by April 1 of the year following the year the account owner turns the applicable age:
  • Born 1951-1959: RMD age is 73
  • Born 1960 or later: RMD age is 75 (effective 2033)
• Still-working exception: under the Internal Revenue Code, an employee who is still employed and is not a 5% owner of the employer can delay the required beginning date for that employer's plan past the applicable age, until April 1 of the year after retirement. A 5% owner must begin at the applicable age regardless of employment. The exception covers only that employer's plan, never an IRA
• Delaying the first RMD: if the first RMD is delayed to April 1 of the year after the applicable age is reached, that delayed distribution AND the regular RMD for the following year are both taxable in that same calendar year, doubling taxable retirement income for that year
• Applies to: Traditional IRAs, 401(k)s, 403(b)s, 457(b)s, and most employer-sponsored plans
• Does NOT apply to Roth IRAs during the owner's lifetime
• Roth 401(k)s also have no RMDs during the owner's lifetime
• Inherited Roth accounts DO have distribution requirements
• Inherited accounts: under the Internal Revenue Code, a beneficiary who is not an eligible designated beneficiary (a surviving spouse, a minor child of the account owner, a disabled or chronically ill individual, or someone not more than 10 years younger than the account owner) must fully distribute the inherited account within 10 years of the owner's death
• Distributions from traditional accounts are taxed as ordinary income

What Is the Penalty for Missing an RMD?

• 25% excise tax on the amount not withdrawn
• Reduced to 10% if corrected within 2 years

Exam Tip: Gotchas

• Roth IRAs have NO required minimum distributions during the owner's lifetime. But inherited Roth accounts DO have distribution requirements; do not confuse the two.

What Is the Penalty for an Early Retirement Distribution?

• Retirement account distributions taken before age 59.5 generally trigger a 10% additional tax, on top of any regular income tax owed on the distribution
• This early withdrawal penalty applies separately from, and in addition to, ordinary income tax on the distribution

What Are the Exceptions to the 10% Early Withdrawal Penalty?

Some exceptions apply to any retirement account, and some apply only to IRAs.

Available for both IRAs and employer plans:

• Death of the account owner
• Permanent disability
• Substantially equal periodic payments: a series of payments based on life expectancy
• Unreimbursed medical expenses: the part of the distribution that does not exceed the medical expenses the taxpayer could deduct for the year, meaning the expenses above the deductible-medical-expense floor
• Birth or adoption: up to $5,000 per child, taken within one year of the birth or finalized adoption

Available for IRAs only, not employer plans such as a 401(k):

• First-time home purchase: up to $10,000 (lifetime limit) used to pay acquisition costs for a first home
• Qualified higher education expenses: no dollar cap
• Health insurance premiums during unemployment: after the individual has received unemployment compensation for 12 consecutive weeks

Exam Tip: Gotchas

• The 10% early withdrawal penalty is separate from ordinary income tax. A pre-59.5 distribution is generally taxable AND penalized unless an exception applies. The exceptions above avoid only the penalty, not the underlying income tax.
• Three of the most-tested exceptions are IRA-only. First-time home purchase, higher education expenses, and unemployment health insurance premiums do not excuse the penalty on a 401(k) distribution. A question that moves the same fact pattern from an IRA to an employer plan is testing exactly this.
• The medical expense exception is measured on the deductible excess, not the whole bill. Only the portion of expenses above the deduction floor counts, so a large bill can still leave most of the distribution penalized.

How Does Investment Income Affect IRMAA?

IRMAA stands for Income-Related Monthly Adjustment Amount. It is a Medicare surcharge on Part B and Part D premiums for high-income beneficiaries.

How Is IRMAA Determined?

• Based on modified adjusted gross income (MAGI) from 2 years prior (e.g., 2024 MAGI determines 2026 IRMAA)
• 2026 threshold: IRMAA applies when individual MAGI exceeds $109,000 (single) or $218,000 (married filing jointly)
• For IRMAA, MAGI is adjusted gross income increased by tax-exempt interest, including municipal bond interest, so a tax-free income strategy can still raise a client's Medicare premiums

What Are the Planning Implications?

• Investment income, capital gains, retirement distributions, and tax-exempt interest (including municipal bond interest) can push MAGI above IRMAA thresholds
• Roth conversions increase MAGI and can trigger IRMAA
• Advisers should consider tax-efficient withdrawal strategies and Roth conversion timing to manage IRMAA exposure

Exam Tip: Gotchas

• IRMAA uses a 2-year lookback. A large capital gain or Roth conversion in one year can trigger higher Medicare premiums two years later. Advisers must consider this when recommending income-generating transactions for retirees.

What Should You Check on Exam Day?

• Short-term = held 1 year or less, taxed at ordinary rates; long-term = held more than 1 year, taxed at 0%, 15%, or 20%
• The holding period starts the day AFTER the purchase trade date and ends on the sale trade date, so a sale exactly one year later is still short-term
• NIIT is a 3.8% surtax on investment income above $200,000 MAGI (single) / $250,000 (married filing jointly)
• Capital losses offset gains dollar-for-dollar with no limit, then up to $3,000/year ($1,500 married filing separately) against ordinary income
• Wash sale: loss disallowed on a substantially identical repurchase within 30 days before or after the sale (61-day window total), added to the replacement security's basis; the rule reaches every account the taxpayer touches, including an IRA, a spouse's account, and an option to buy, and the IRA repurchase destroys the loss permanently instead of deferring it
• Qualified dividends need a U.S. or qualified foreign corporation payer plus a holding period of more than 60 days in the 121-day window around the ex-dividend date; REIT dividends are ordinary income
• Inherited assets get a basis reset to FMV at death, a step-up or step-down (long-term holding period automatic); gifted assets carry over the donor's basis and the donor's holding period
• Basis moves after purchase: return of capital, depreciation, and deducted casualty losses reduce it; reinvested dividends increase it
• FIFO is the default lot-selection method and usually the largest gain; specific identification gives the most tax-planning flexibility; average cost is limited to mutual fund and dividend reinvestment plan shares, and a switch away from it applies only going forward
• Marginal rate applies to the last dollar of income; effective rate is always lower
• AMT adds back preference items (ISO spreads, private activity municipal bond interest) and taxes at 26%/28%; the taxpayer pays the greater of regular tax or AMT
• RMD age is 73 (born 1951-1959) or 75 (born 1960+, effective 2033); Roth IRAs and Roth 401(k)s have no lifetime RMDs, but inherited Roth accounts do; a still-working employee who is not a 5% owner can delay the required beginning date for that employer's plan past the applicable age; delaying the first RMD means two RMDs are taxable that same year; a beneficiary who is not an eligible designated beneficiary must empty an inherited account within 10 years
• A pre-59.5 retirement distribution generally triggers a 10% early withdrawal penalty on top of income tax; death, disability, substantially equal periodic payments, deductible unreimbursed medical expenses, and $5,000 per child for birth or adoption excuse it for any account, while the $10,000 lifetime first-time home purchase, qualified higher education expenses, and unemployment health insurance premiums are IRA-only
• IRMAA uses a 2-year MAGI lookback and can be triggered by capital gains, Roth conversions, or tax-exempt interest such as municipal bond interest (MAGI for IRMAA adds back tax-exempt interest)