Individual Tax Planning for the CPA Exam
The REG section of the CPA exam tests your ability to apply individual tax rules and identify planning opportunities. Understanding the structure of the individual income tax formula and the interplay between deductions, credits, and tax rates is essential.
The Individual Tax Formula
| Line | Description |
|---|---|
| Gross Income (§61) | All income from whatever source derived |
| − Above-the-line deductions (§62) | Deductions FOR AGI |
| = Adjusted Gross Income (AGI) | Key threshold for many limitations |
| − Greater of standard or itemized deductions | Deductions FROM AGI |
| − Qualified business income deduction (§199A) | Up to 20% of QBI |
| = Taxable Income | Subject to tax rate schedule |
| × Tax Rates | 10%, 12%, 22%, 24%, 32%, 35%, 37% |
| = Regular Tax Liability | |
| + AMT (if applicable) | Alternative minimum tax |
| − Credits | Nonrefundable then refundable |
| = Net Tax Due / Refund |
Above-the-Line Deductions (Deductions FOR AGI)
These deductions reduce AGI and are therefore available regardless of whether the taxpayer itemizes. Key deductions include:
- Educator expenses: Up to $300 for qualified K-12 teachers
- Self-employment tax: 50% of self-employment tax is deductible (§164(f))
- Self-employed health insurance: 100% deductible for the self-employed individual, spouse, and dependents
- IRA contributions: Traditional IRA deduction, subject to AGI phaseouts if covered by an employer plan
- Student loan interest: Up to $2,500, subject to AGI phaseout
- HSA contributions: Deductible contributions to a health savings account (must have a high-deductible health plan)
- Alimony: Deductible only for divorce/separation agreements executed before January 1, 2019 (post-2018 agreements: not deductible by payor, not income to recipient)
Standard Deduction vs. Itemized Deductions
Taxpayers choose the greater of the standard deduction or total itemized deductions. Key itemized deductions (Schedule A) include:
- State and local taxes (SALT): State/local income tax (or sales tax election), real property tax, and personal property tax - capped at $10,000 combined ($5,000 MFS)
- Mortgage interest: Interest on acquisition indebtedness up to $750,000 ($375,000 MFS) for loans originating after December 15, 2017. Home equity loan interest is deductible only if proceeds are used to buy, build, or improve the home.
- Charitable contributions: Cash contributions up to 60% of AGI (100% for qualified disaster relief); long-term capital gain property at FMV up to 30% of AGI. Excess carries forward 5 years.
- Medical expenses: Deductible to the extent they exceed 7.5% of AGI
- Casualty and theft losses: Only federally declared disaster losses are deductible (post-TCJA), subject to $100 per-event floor and 10% of AGI aggregate floor
Tax Credits
Credits directly reduce tax liability and are therefore more valuable than deductions. Key individual credits:
- Child tax credit (§24): Up to $2,000 per qualifying child under age 17, with a refundable portion (additional child tax credit)
- Child and dependent care credit (§21): 20-35% of qualifying expenses up to $3,000 (one qualifying individual) or $6,000 (two or more)
- American Opportunity Credit (§25A): Up to $2,500 per student for the first 4 years of postsecondary education (40% refundable)
- Lifetime Learning Credit: Up to $2,000 per return for any postsecondary education (nonrefundable)
- Earned Income Tax Credit: Refundable credit for low-to-moderate income workers; amount depends on filing status and number of qualifying children
- Retirement Savings Contributions Credit (§25B): Nonrefundable credit up to $1,000 ($2,000 MFJ) for low-income taxpayers contributing to IRAs or employer plans
Capital Gains Tax Planning
Long-term capital gains (assets held more than 12 months) are taxed at preferential rates of 0%, 15%, or 20%, plus the 3.8% net investment income tax for high earners. Planning strategies include:
- Tax-loss harvesting: Realizing capital losses to offset capital gains. Net capital losses can offset up to $3,000 of ordinary income per year, with unlimited carryforward.
- Holding period management: Ensure assets are held long enough to qualify for long-term treatment.
- Wash sale rule (§1091): A loss is disallowed if substantially identical securities are purchased within 30 days before or after the sale. The disallowed loss is added to the basis of the replacement shares.
- Qualified Opportunity Zone investments (§1400Z-2): Deferral and potential exclusion of capital gains invested in designated economically distressed communities.
Alternative Minimum Tax (AMT)
The AMT exists as a parallel tax system to ensure taxpayers with significant preference items or adjustments pay a minimum amount of tax. Key AMT adjustments include the SALT deduction add-back, private activity bond interest, and ISO stock option exercise spread. The AMT exemption amount phases out for high-income taxpayers. The AMT rate is 26% on the first $220,700 (2023 MFJ) and 28% on the excess.
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