Use Buckets to Understand Tax Concepts - dummies

Use Buckets to Understand Tax Concepts

By Kenneth W. Boyd

The regulation (REG) test on the CPA exam requires a student to learn dozens of tax rules. One way to clarify these tax rules is to use a bucket as a learning tool.

Consider individual taxation, which is computed on Form 1040. A taxpayer fills up the bucket with taxable income. Taxable income includes wages as well as dividends, interest, and earnings from self-employment. At that bottom on Page 1 of the 1040, you see a list of adjustments to income. These amounts reduce taxable income. For example, self-employed individuals can deduct a portion of their health insurance premiums. Visualize the taxpayer using a small shovel and taking some income out of the bucket.

The top of Page 2 of Form 1040 covers the individual and standard deductions as well as exemptions. Both deductions and exemptions reduce income, so the taxpayer’s shovel takes more income out of the bucket.

After making all the changes to income, you use the taxable income to calculate your tax liability. That taxable amount is reduced by credits and increased by other taxes, such as self-employment tax. After the taxpayer has a final tax amount, imagine cutting a hole in the bottom of the bucket. Some of your income comes out of the bucket to pay taxes. After you pay taxes, you plug the hole of the bottom of the bucket.

Form 1040 is a great tool for studying the tax concepts on the REG test. When you need to study tax rules for a given topic, consider where that tax issue is posted on Form 1040. The bucket analogy helps you visualize the process of accumulating income, making adjustments, and paying taxes.