Understanding Individual Income Tax Fundamentals
Individual income taxation under the Internal Revenue Code forms the foundation for the REG exam's taxation section. The basic formula is: Gross Income minus Deductions equals Taxable Income.
What Counts as Gross Income
Gross income includes all income from any source, including wages, salaries, interest, dividends, rental income, and capital gains. The IRS takes a broad view of income inclusion. Prizes, awards, and bartered services must all be included at fair market value.
Understanding realization is essential. Income must be realized through a taxable event before inclusion. Asset appreciation alone does not create taxable income until you sell or exchange the asset.
Ordinary Income vs. Capital Gains
You must distinguish between ordinary income and capital gains because they receive different tax treatment. Ordinary income is taxed at progressive rates from 10% to 37% in 2024. Capital gains enjoy preferential rates based on holding periods.
Tax Bracket Mechanics
The progressive tax rate structure means different portions of income are taxed at different rates. For 2024, federal rates range from 10% to 37% for individuals. Understanding how income flows through brackets and calculating total tax liability is fundamental to exam success.
Deductions: Above-the-Line and Below-the-Line
Deductions reduce taxable income and fall into two main categories: above-the-line deductions and below-the-line deductions. Understanding each category is critical for calculating adjusted gross income (AGI).
Above-the-Line Deductions
Above-the-line deductions, also called adjustments to income, reduce gross income to arrive at AGI. Common examples include:
- Traditional IRA contributions
- Student loan interest (up to $2,500)
- Educator expenses
- One-half of self-employment tax
AGI is a critical threshold because many tax benefits phase out based on AGI levels. Lower AGI directly improves your tax position by qualifying you for more credits and deductions.
Below-the-Line Deductions
Below-the-line deductions consist of either the standard deduction or itemized deductions. The 2024 standard deduction is $14,600 for single filers and $29,200 for married filing jointly, adjusted annually for inflation.
Itemized deductions include:
- Mortgage interest
- State and local taxes (capped at $10,000)
- Charitable contributions
- Medical expenses exceeding 7.5% of AGI
Taxpayers choose whichever produces lower taxable income. Understanding when deductions apply, what limitations exist, and how they interact with income is essential for REG success.
Capital Gains and Investment Income Taxation
Capital gains taxation represents a significant REG exam area. Capital gains are profits from selling capital assets, categorized by holding period.
Short-Term vs. Long-Term Capital Gains
Short-term capital gains result from assets held one year or less. These are taxed as ordinary income at rates up to 37%. Long-term capital gains result from assets held longer than one year and receive preferential treatment.
Long-term capital gains rates are 0%, 15%, or 20% depending on taxpayer income level. For example, a single 2024 taxpayer pays 0% on long-term gains up to $47,025, then 15% from $47,025 to $518,900, and 20% above that.
Basis and Realized Gain
Basis is generally the cost of the asset, adjusted for improvements, depreciation, and stock splits. The amount realized equals proceeds received. The gain or loss equals amount realized minus adjusted basis.
Inherited property receives a step-up in basis to fair market value at death. This eliminates pre-death appreciation from taxation, a major planning consideration.
Capital Loss Limitations
Individuals can deduct only $3,000 of net capital losses against ordinary income annually. Excess losses carry forward indefinitely. Qualified dividend income also receives preferential long-term capital gains rates if dividends come from qualifying corporations and meet holding requirements.
Tax Credits and Advanced Concepts
Tax credits are dollar-for-dollar reductions in tax liability, making them more valuable than equivalent deductions. Understanding credits and the Alternative Minimum Tax is crucial for advanced REG preparation.
Common Tax Credits
Key credits and their 2024 amounts include:
- Child Tax Credit: $2,000 per qualifying child under age 17, phases out starting at $400,000 (married filing jointly)
- Earned Income Tax Credit (EITC): $560 to $3,995, depending on income and children
- American Opportunity Tax Credit: up to $2,500 for education expenses
- Lifetime Learning Credit: up to $2,000
- Saver's Credit: up to $1,000 for retirement savings
Refundable credits can result in a tax refund if they exceed tax liability. Non-refundable credits can only reduce tax liability to zero. Know which credits fall into each category.
Alternative Minimum Tax (AMT)
AMT is a parallel tax system ensuring high-income individuals pay minimum tax. The AMT uses 26% on the first $215,250 of alternative minimum taxable income and 28% above that, with an $85,900 exemption for married filing jointly.
Preferences and adjustments increasing AMT include depreciation differences, incentive stock options, and private activity bond interest. Understanding when AMT applies and calculating it correctly is essential.
Self-Employment Tax and Retirement Planning for Individuals
Self-employed individuals face unique tax considerations involving self-employment tax calculation and retirement planning options.
Self-Employment Tax Rate and Calculation
Self-employment tax is 15.3% total: 12.4% for Social Security (on net self-employment income up to $168,600 for 2024) and 2.9% for Medicare (on all net income with an additional 0.9% Medicare tax above $200,000 for single filers).
The calculation begins with net self-employment income from Schedule C, reduced by the deductible portion of self-employment tax. One-half of self-employment tax is an above-the-line adjustment reducing AGI.
Quarterly estimated tax payments are required if combined self-employment tax and income tax liability will exceed $1,000.
Retirement Planning Options
Self-employed individuals have several retirement savings options:
- SEP IRA: contributions up to 20% of net self-employment income (reduced by one-half SE tax), maximum $69,000 in 2024
- Solo 401(k): higher contribution limits and loan options for self-employed with no employees
- SIMPLE IRA: lower contribution limits but simpler administration
Traditional IRA contributions are deductible if not an active participant in an employer plan or income is below thresholds. Roth IRA contributions are not deductible but allow tax-free growth and withdrawals if requirements are met. Understanding these interactions is essential for exam success.