CFP - Tax Planning (14% of the exam) - Section E.37

Income tax fundamentals and calculations

Computing gross income, adjustments, adjusted gross income, itemised versus standard deductions, taxable income, tax liability, credits and payments; the net investment income tax and additional Medicare tax; and estimated tax and penalty rules.

Form 1040Internal Revenue Code Section 1411

Practice question for this objective

Free sampleTax Planninghard

Tom and Ruth file a joint return. Tom's wages are 240,000 dollars and the couple has 60,000 dollars of net investment income consisting of interest, qualified dividends and a long-term capital gain. They have no adjustments, so their modified adjusted gross income is 300,000 dollars. Assume the net investment income tax rate is 3.8 percent with a modified adjusted gross income threshold of 250,000 dollars for joint filers, and that the additional Medicare tax on earned income is 0.9 percent above the same threshold. How much net investment income tax do they owe?

AZero dollars, because Tom's wages of 240,000 dollars fall below the 250,000 dollar threshold
B1,900 dollars, because the 50,000 dollar excess is smaller than the investment income figure Correct
C450 dollars, because the 50,000 dollars of excess income carries the 0.9 percent surtax rate
D2,280 dollars, because all 60,000 dollars of net investment income carries the 3.8 percent rate

The net investment income tax base is the lesser of net investment income and the excess of modified adjusted gross income over the filing status threshold. Modified adjusted gross income is 240,000 plus 60,000, so 300,000 dollars. The excess over the 250,000 dollar joint threshold is 50,000 dollars. Net investment income is 60,000 dollars. The tax applies to the lesser of the two figures, so the base is 50,000 dollars. Multiplying 50,000 by 0.038 gives 1,900 dollars. Wages are never net investment income, but they do raise modified adjusted gross income and so they push the couple over the threshold. The additional Medicare tax is a separate charge on earned income and is zero here because wages of 240,000 dollars do not exceed 250,000 dollars.

Why A is wrong: This measures the threshold against earned income alone, which is the test for the additional Medicare tax; the net investment income tax measures modified adjusted gross income, and investment income counts toward it.

Why B is correct: The base is the lesser of net investment income of 60,000 dollars and the 50,000 dollar excess of modified adjusted gross income over the threshold, and 50,000 dollars at 3.8 percent produces 1,900 dollars.

Why C is wrong: This finds the correct 50,000 dollar excess but applies the 0.9 percent additional Medicare tax rate, which applies only to earned income; the net investment income tax rate is 3.8 percent.

Why D is wrong: This applies the correct rate but skips the lesser-of test, taxing the whole 60,000 dollars of investment income; the base is capped at the amount by which modified adjusted gross income exceeds the threshold, which is 50,000 dollars.

See more CFP practice questions, answers explained.

Exam traps in Tax Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

Accept that the 42,000 dollars is taxed to the trust at its compressed rates, because income accumulated by a trust in a closed tax year cannot afterwards be shifted to a beneficiary by any distribution the trustee makes.
Why it is wrong: Tempting because annual accounting is the general rule and a closed year is usually closed for good. It is wrong because the 65 day rule is a statutory exception that lets an early distribution be pushed back into the prior year when the trustee elects it on that year's return.
27,636.40 dollars
Why it is wrong: This applies the wage base ceiling correctly but forgets the 92.35 percent step for the Medicare portion, charging 2.9 percent on the full 200,000 of net profit rather than on 184,700 of net earnings. Both portions run off net earnings, not net profit.
Holding back the invoicing of work completed in December until January, so that the fee is genuinely received and then reported in the following tax year.
Why it is wrong: Tempting because the timing is chosen purely for tax reasons, but a cash basis taxpayer who has not yet been paid has no income to report, so shifting when he bills is lawful avoidance.

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