Income Tax Fundamentals

Understanding the federal income tax system begins with mastering the basic tax formula. This formula is the foundation for all tax planning and is heavily tested on the CFP exam.

The Basic Tax Formula

The tax formula is a step-by-step process that transforms your total economic income into your final tax liability:

Exclusions vs. Deductions

Understanding the difference between exclusions and deductions is critical:

Exclusions

Exclusions are items that are permanently removed from gross income and never taxed. Common exclusions include:

• Gifts and inheritances received
• Life insurance death benefits (generally)
• Municipal bond interest
• Qualified Roth IRA distributions
• Employer-paid health insurance premiums
• First $50,000 of group term life insurance
• Scholarships used for tuition, fees, and books
• Gain on sale of principal residence (up to $250,000/$500,000 under Section 121)

Deductions

Deductions reduce taxable income but are subject to various limitations and requirements. They come in two types:

CFP Exam Tip: Above-the-line deductions are more valuable because they reduce AGI, which affects eligibility for many tax benefits that phase out based on AGI.

Understanding Adjusted Gross Income (AGI)

AGI is one of the most important numbers on a tax return. It serves as a threshold for many tax benefits and limitations:

• Medical expense deduction floor (7.5% of AGI)
• Casualty loss floor (10% of AGI for federally declared disasters)
• Phaseouts for tax credits (Child Tax Credit, education credits)
• Eligibility for Roth IRA contributions
• Passive activity loss allowance phaseout ($100,000-$150,000 AGI)
• Student loan interest deduction phaseout

Common Above-the-Line (FOR AGI) Deductions:

1. Trade or business expenses (Schedule C)
2. Rental and royalty expenses
3. One-half of self-employment tax
4. Self-employed health insurance premiums (100%)
5. Contributions to SEP, SIMPLE, and qualified plans
6. Traditional IRA contributions (if eligible)
7. Student loan interest (up to $2,500)
8. Health Savings Account (HSA) contributions
9. Penalty on early withdrawal from savings
10. Alimony paid (for divorces finalized before 2019)

Progressive Taxation: Understanding Tax Brackets

The U.S. federal income tax system is progressive, meaning tax rates increase as income increases. For 2025, there are seven tax brackets:

How Progressive Taxation Works

In a progressive system, only the income within each bracket is taxed at that bracket's rate. For example, if a single filer has $60,000 of taxable income in 2025:

• First $11,925 taxed at 10% = $1,192.50
• Next $36,550 ($11,926 to $48,475) taxed at 12% = $4,386.00
• Remaining $11,525 ($48,476 to $60,000) taxed at 22% = $2,535.50
• Total Tax: $8,114.00

Marginal vs. Effective Tax Rate

Using the example above:

• Marginal Rate: 22% (the bracket the last dollar falls into)
• Effective Rate: $8,114 / $60,000 = 13.52%

Planning Application: A client in the 22% marginal bracket who is deciding whether to contribute to a traditional IRA will save $0.22 in taxes for every dollar contributed. However, their overall tax burden is only about 13.5% of their taxable income.

Tax Credits: Dollar-for-Dollar Savings

Unlike deductions that reduce taxable income, tax credits reduce tax liability dollar-for-dollar. There are two types:

CFP Exam Tip: Tax credits are always more valuable than deductions of the same dollar amount. A $1,000 credit saves $1,000 in taxes, while a $1,000 deduction saves only $220 for someone in the 22% bracket.

The Complete Picture: Putting It Together

Understanding how all these concepts work together is essential for tax planning:

1. Maximize exclusions - Ensure all tax-free income is properly excluded
2. Claim all above-the-line deductions - These reduce AGI and benefit everyone
3. Compare itemized vs. standard deduction - Choose the greater amount
4. Apply available credits - Credits provide the most tax savings per dollar
5. Consider marginal rates - Make planning decisions based on marginal impact