Income Tax Fundamentals: Individual

Understanding how individuals are taxed on investment income is the foundation of tax-aware advising. This section covers the core tax rules that drive client decisions about when to sell, what to hold, and how to structure income.

How Are Capital Gains and Losses Taxed?

When a client sells an investment for more than its cost basis, the profit is a capital gain. When sold for less, it is a capital loss. The tax treatment depends on how long the asset was held.

• The holding period starts the day after purchase and includes the day of sale
• Long-term capital gains rates depend on the taxpayer's total taxable income
• The 0% rate applies to lower-income taxpayers, the 15% rate covers most filers, and the 20% rate applies only to the highest earners

Net Capital Losses:

• Capital losses first offset capital gains of the same type (short-term offsets short-term, long-term offsets long-term)
• Any remaining net capital loss can offset up to $3,000 of ordinary income per year ($1,500 if married filing separately)
• Unused capital losses carry forward indefinitely to future tax years

Exam Tip: Gotchas

• The $3,000 limit applies to ordinary income only. There is no limit on using capital losses to offset capital gains. A client with $50,000 in capital losses and $45,000 in capital gains uses $45,000 against gains and $3,000 against ordinary income, carrying forward $2,000.
• "More than 12 months" means at least a year and a day. An asset bought on January 1 and sold on January 1 of the next year is short-term. Selling on January 2 makes it long-term.

What Is the Wash Sale Rule?

The wash sale rule prevents investors from claiming a tax loss while maintaining their economic position in the same security.

• A loss is disallowed if the investor buys a substantially identical security within 30 days before or 30 days after the sale
• This creates a 61-day window (30 days before + sale date + 30 days after)
• "Substantially identical" includes the same stock, options or contracts to buy the same stock, and the same security in a different account (including an IRA or spouse's account)
• Buying stock in a different company in the same industry is generally not a wash sale

When a wash sale is triggered:

• Generally, the disallowed loss is added to the cost basis of the replacement security, and the holding period of the old security carries over to the new one; the loss is deferred, not permanently lost, until the replacement security is sold
• Exception: if the replacement security is bought inside an IRA (traditional or Roth), the loss is permanently disallowed with no basis adjustment

Exam Tip: Gotchas

• The wash sale rule applies to losses only. There is no corresponding rule for gains.
• The 30-day window runs in both directions. Buying the replacement security before selling the loss position also triggers the rule.
• Buying the replacement in an IRA is worse than buying it in a regular account. The loss is gone for good, not deferred, because there is no basis to add it to in a way that will ever produce a taxable benefit.

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 (0%, 15%, or 20%), while ordinary (non-qualified) dividends are taxed at the taxpayer's regular income tax rate.

Requirements for qualified dividend treatment:

• Paid by a U.S. corporation or a qualified foreign corporation
• The shareholder must meet the holding period requirement: the stock must be held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date

Exam Tip: Gotchas

• The holding period for qualified dividends is separate from the capital gains holding period. A stock held for 45 days that pays a dividend produces a non-qualified dividend (taxed at ordinary rates) even if the stock is later held long enough to qualify for long-term capital gains treatment on the sale.

What Determines an Investment's Tax Basis?

Tax basis (also called cost basis or adjusted basis) is the starting point for calculating gain or loss when an investment is sold.

Formula: Gain or Loss = Sale Price - Adjusted Basis

The original purchase price is adjusted for:

• Stock splits: Basis is divided among additional shares (same total basis, more shares)
• Reinvested dividends: Each reinvestment adds to the total basis
• Return of capital: Distributions that are a return of capital reduce the basis
• Improvements: For real estate, capital improvements increase the basis

Special basis rules:

Gifted property sold at a loss (the dual basis rule): carryover basis applies only when the sale produces a gain. If the FMV at the time of the gift was lower than the donor's basis (the property had already lost value), the recipient has a split basis:

• Gain: use the donor's original basis
• Loss: use the FMV at the time of the gift (the lower figure), not the donor's basis
• Sale price falls between the FMV at gift and the donor's basis: no gain or loss is reported

Example: Donor's basis is $20/share; FMV at the time of the gift is $12/share. Sell at $25 → $5 gain (uses the $20 donor's basis). Sell at $8 → $4 loss (uses the $12 FMV). Sell at $15 → no gain or loss (between $12 and $20).

Exam Tip: Gotchas

• Gift basis vs. inherited basis is frequently tested. Gifts carry over the donor's basis (and potentially the donor's holding period). Inherited capital property gets a new basis at fair market value, which generally eliminates unrealized gains on appreciated assets (a declined asset instead gets a step-down). Some inherited assets, like traditional IRAs, are income in respect of a decedent and remain taxable as ordinary income instead.
• For gifted property sold at a loss, special rules may apply: if the FMV at the time of the gift was lower than the donor's basis, the recipient uses the FMV as basis for calculating a loss (the "double basis" rule for gifts). This only governs losses; carryover basis still applies for gains.

What Is the Difference Between Marginal and Effective Tax Rates?

The U.S. uses a progressive tax system where income is taxed in layers, with each layer taxed at a higher rate.

• The marginal tax rate is the rate applied to the last dollar of taxable income
• The effective tax rate is the total tax divided by total income (generally lower than the marginal rate)
• Federal income tax brackets range from 10% to 37% (2026)

Why this matters for advisers:

• The marginal rate determines the after-tax benefit of deductions: a $10,000 deduction saves $3,700 for a client in the 37% bracket but only $1,200 for a client in the 12% bracket
• The marginal rate determines the tax cost of additional income: adding $10,000 of interest income to a client in the 32% bracket costs $3,200 in taxes
• Advisers use marginal rates to compare taxable vs. tax-exempt investments

Exam Tip: Gotchas

• Marginal rate and effective rate are often confused. The marginal rate applies only to the next dollar earned, not to total income. A client "in the 32% bracket" does not pay 32% on all income.

What Is the Alternative Minimum Tax (AMT)?

The Alternative Minimum Tax is a parallel tax calculation designed to ensure that taxpayers who benefit from certain deductions and exclusions still pay a minimum amount of tax.

How it works:

1. Start with regular taxable income
2. Add back certain preference items and adjustments
3. Subtract the AMT exemption ($90,100 for single filers, $140,200 for married filing jointly, 2026)
4. Apply AMT rates (26% on the first $244,500 of AMT income for most filers, 28% on the excess; the breakpoint is half that amount for married filing separately, 2026)
5. The taxpayer pays the greater of regular tax or AMT

Common AMT preference items:

• Incentive stock option (ISO) exercise spread: The difference between the exercise price and fair market value (FMV) at exercise
• Private activity bond interest: Interest from certain municipal bonds that is normally tax-exempt
• Accelerated depreciation: Excess of accelerated depreciation over straight-line

The AMT exemption phases out at higher income levels (above $500,000 single / $1,000,000 married filing jointly for 2026), reducing by $0.50 for every $1 of AMT income above the phaseout threshold.

Exam Tip: Gotchas

• ISO exercise is the most commonly tested AMT trigger. The spread between the exercise price and the stock's FMV at exercise is not taxed for regular income tax purposes but is an AMT preference item.
• Private activity bond interest is another tested item. Not all municipal bond interest is exempt from AMT.

How Are Retirement Plan Distributions Taxed?

Distributions from tax-deferred retirement accounts have specific tax rules that advisers must understand.

Traditional IRAs, traditional 401(k)s, and other pre-tax retirement plans:

• Contributions were made pre-tax (or were tax-deductible)
• Distributions are taxed as ordinary income, to the extent they represent pre-tax contributions and growth. A Traditional IRA can also hold non-deductible (after-tax) contributions; that basis is not taxed again on withdrawal
• Early distributions (before age 59 1/2) are generally subject to ordinary income tax plus a 10% early withdrawal penalty, though several exceptions apply (e.g., death, disability, certain medical expenses)
• Required Minimum Distributions (RMDs) must begin at age 73, rising to age 75 for those born in 1960 or later (per the SECURE 2.0 Act)

Roth IRA distributions:

• Contributions were made with after-tax dollars
• Qualified distributions are completely tax-free (both contributions and earnings)
• A qualified distribution requires the account to be open for at least 5 years, and the owner to be 59 1/2 or older, disabled, deceased, or a first-time homebuyer up to $10,000

Exam Tip: Gotchas

• The 10% early withdrawal penalty is in addition to ordinary income tax. A $10,000 early distribution to a client in the 24% bracket costs $2,400 in income tax plus $1,000 in penalties, totaling $3,400.
• Roth IRAs have no RMDs during the owner's lifetime. This makes them a powerful estate planning tool.

How Does Investment Income Affect Government Benefits?

Investment income does not exist in a vacuum. It can affect the taxation of Social Security benefits and trigger Medicare premium surcharges.

Social Security Taxation:

• Provisional income = Adjusted Gross Income (AGI) + tax-exempt interest + 50% of Social Security benefits
• If provisional income exceeds certain thresholds, a portion of Social Security benefits becomes taxable

• These thresholds are not indexed for inflation, meaning more retirees become subject to this tax over time

Medicare IRMAA Surcharges:

• Income-Related Monthly Adjustment Amount (IRMAA) increases Medicare Part B and Part D premiums for higher-income beneficiaries
• Based on Modified Adjusted Gross Income (MAGI) from two years prior
• Investment income (capital gains, dividends, interest) counts toward MAGI

Exam Tip: Gotchas

• Tax-exempt interest counts toward provisional income for Social Security taxation. Municipal bond interest, while exempt from regular income tax, can cause Social Security benefits to become taxable.
• IRMAA uses a two-year lookback. A large capital gain today affects Medicare premiums two years from now.

What Should You Check on Exam Day?

• Long-term (more than 12 months) gains and qualified dividends get preferential rates of 0%, 15%, or 20%; short-term gains and non-qualified dividends are taxed at ordinary rates up to 37%
• Net capital losses offset gains without limit, but only up to $3,000 of ordinary income per year, with an indefinite carryforward
• The wash sale rule disallows a loss when a substantially identical security is bought within 30 days before or after the sale (a 61-day window); it applies to losses only
• Gift basis carries over from the donor; inherited capital property's basis steps up (or down) to fair market value at death; inherited traditional IRAs and other income in respect of a decedent are an exception and stay taxable as ordinary income
• The qualified-dividend holding period (more than 60 days in the 121-day window around the ex-dividend date) is separate from the capital-gains holding period
• AMT exemption for 2026 is $90,100 single / $140,200 married filing jointly; the taxpayer pays the greater of regular tax or AMT
• RMDs from traditional accounts begin at age 73 (75 for those born 1960 or later); early withdrawals before 59 1/2 trigger a 10% penalty on top of ordinary income tax; Roth qualified distributions are tax-free with no lifetime RMDs
• Tax-exempt interest still counts toward provisional income for Social Security taxation, and Medicare IRMAA surcharges use a two-year MAGI lookback