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.

Capital Gains and Losses

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
• 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.

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:

• The disallowed loss is added to the cost basis of the replacement security
• The holding period of the old security carries over to the new one
• The loss is not permanently lost; it is deferred until the replacement security is sold

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.

Qualified Dividends

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.

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:

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 assets get a new basis at fair market value, which eliminates all unrealized gains.
• 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).

Marginal Tax Bracket

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 (always lower than the marginal rate)
• Federal income tax brackets for 2024 range from 10% to 37%

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.

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 ($85,700 for single filers, $133,600 for married filing jointly in 2024)
4. Apply AMT rates (26% on the first $248,300 of AMT income, 28% on the excess)
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, 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.

Pension and Retirement Plan Distributions

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

Traditional IRAs, 401(k)s, and other tax-deferred plans:

• Contributions were made pre-tax (or were tax-deductible)
• All distributions are taxed as ordinary income
• Early distributions (before age 59 1/2) are subject to ordinary income tax plus a 10% early withdrawal penalty
• Required Minimum Distributions (RMDs) must begin at age 73 (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 (or disabled, 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.

Government Benefit Implications

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 in 2024 affects Medicare premiums in 2026.