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.

Capital Gains

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

• 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

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

Net Capital Loss Rules

• Net 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.

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)

Exam Tip: Gotchas

• The disallowed loss is not permanently lost. It gets added to the replacement security's basis, deferring the tax benefit.

Qualified Dividends

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.

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

Tax Rates

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

Dividends That Are NOT Qualified

These are taxed as ordinary income:

• REIT dividends - ordinary income (not qualified dividends)
• Master limited partnership (MLP) distributions - mostly return of capital; K-1 income taxed at ordinary rates
• 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.

Tax Basis

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

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)

Stepped-Up Basis at Death

• Inherited assets receive a new cost basis equal to fair market value (FMV) at date of death
• Eliminates all embedded capital gains that built up during the decedent's lifetime
• Holding period is automatically long-term regardless of how long the decedent held the asset

Carryover Basis 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 recipient's basis for determining a loss is the FMV at time of gift

Inherited vs. Gifted Basis Comparison

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 (step-up). Gift = Grandfather the basis (carryover).

Exam Tip: Gotchas

• Inherited = step-up to FMV. Gifted = carryover of donor's basis. These produce opposite outcomes and are commonly tested together.
• If a question asks about eliminating capital gains, the answer involves inheritance, not gifting.

Marginal Bracket

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.

Key Definitions

• 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.

2026 Federal Brackets

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

• 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.

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 It Works

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 approximately $244,500)
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.

Common AMT Triggers (Preference Items)

• 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.

Pension and Retirement Plan Distributions

Required Minimum Distributions (RMDs)

• 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 (SECURE Act 2.0)
  • Born 1960 or later: RMD age is 75 (effective 2033)
• 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 starting in 2024 (SECURE Act 2.0 change)
• Inherited Roth accounts DO have distribution requirements
• Distributions from traditional accounts are taxed as ordinary income

Penalty for Missing 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.

Government Benefit Implications (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 IRMAA Is 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)

Planning Implications

• Investment income, capital gains, and retirement distributions 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.