Much Appreciated

Richard Connor

WHAT’S YOUR CAPITAL gains tax rate? It’s a crucial number to know—and it could open the door to some big tax savings.

Most investors are aware that there’s a significant difference between the tax rate on short-term capital gains—investments held for a year or less—and that on long-term gains, those held more than a year. Realized short-term gains are dunned as ordinary income, just like your salary or any interest income you earn, while long-term appreciation gets taxed at a lower rate.

What’s less understood is how the relationship between capital gains and ordinary income—and the order in which they’re taxed—can impact your marginal tax rate. Understanding those rules can open up a host of tax planning opportunities.

Some background: Capital gains are part of your adjusted gross income, or AGI. Your AGI drives the tax rate you pay not only on ordinary income, but also on long-term gains. That capital gains rate will be lower than the rate on earned income. In fact, if your AGI is low enough to put you in the bottom two income tax brackets, your long-term capital gains tax rate will be zero, unless you’re right at the top of the 12% bracket.

From there, the capital gains rate jumps to 15% and then, at high levels of income, to 20%. On top of that, those with capital gains may face a 3.8% “net investment income tax,” also known as the Medicare surcharge or surtax, which kicks in at $200,000 for single individuals and $250,000 for those married filing jointly. The accompanying table shows 2020’s seven ordinary income brackets, three long-term capital gains brackets and two Medicare surcharge brackets.

The key thing to understand: Long-term capital gains are taxed as additional income, on top of your ordinary income, which means capital gains won’t push your ordinary income into a higher bracket. To see why that’s important, consider a married couple, Joe and Mary.

They’re retired with a pension of $84,800. After subtracting 2020’s standard deduction of $24,800, they’re left with taxable income of $60,000, which puts them in the 12% bracket. Their federal tax bill would be $6,805. If they also realized a $20,000 long-term capital gain, their income would increase to $104,800. Factoring in the standard deduction, that puts their taxable income at $80,000. That $80,000 still keeps them within the 0% long-term capital gains tax bracket, so the $20,000 gain triggers no extra tax and the amount owed to Uncle Sam remains at $6,805. Sweet deal, right?

What if they had chosen to make a $20,000 withdrawal from a traditional IRA, instead of realizing that capital gain. In that case, the entire $20,000 IRA withdrawal would be treated as ordinary income and taxed at their marginal rate of 12%. Result: Their tax bill would be $9,205, an increase of $2,400.

Now, let’s assume they needed $40,000 in additional income, so they took both the $20,000 IRA withdrawal and the $20,000 capital gain. This pushes their income to $124,800, or $100,000 after subtracting the standard deduction. This is $20,000 above the top of the 0% capital gains bracket, which caps out at $80,000, so their $20,000 long-term capital gain is now taxed at 15%, or $3,000, and their total tax bill would be $12,205.

What if, instead, they took a $40,000 IRA withdrawal? Again, their taxable income is $100,000, but now it’s all income and the amount over $80,250 is taxed at the 22% income tax rate, triggering a total tax bill of $13,580. What if they realized a $40,000 long-term capital gain? There’s no change in their total income, but the amount over $80,000 is now a capital gain taxed at 15% and their tax bill is $9,805. The table below details the five examples. It also includes Joe and Mary’s gross tax rate, which is their tax bill divided by their gross income.

(A digression: Joe and Mary’s capital gain isn’t just taxed at a lower rate, which means they have more left after taxes. On top of that, we’re talking here about the tax on their gain, not the total value of the investments sold. If Mary and Joe sold $40,000 in stock, the taxable portion might be, say, $15,000, assuming their cost basis on the stock was $25,000. Alternatively, if Mary and Joe wanted to net $40,000 after taxes, they’d need to sell more than $40,000 in stock. Let’s say they sold $45,300 of stock with a cost basis of $10,000, so their realized gain was $35,300. If that gain was taxed at 15%, they would be left with some $40,000 after the taxes on their $45,300 stock sale.)

Although simple, the above examples demonstrate that carefully analyzing which assets to draw on, and in what order, can make a significant difference to your tax bill. When does this kind of analysis come in handy? If you have a year with unusually high income, perhaps because of a Roth conversion or a big year-end bonus, realizing capital gains may be the better bet if you need extra cash. On the other hand, if your taxable income is unusually low—perhaps you just retired or you have high medical deductions—drawing on your retirement accounts, and generating more ordinary income, could be the smarter move.

What if you have an especially challenging situation to analyze? I’d recommend using tax software to make sure you capture all the complex interactions. And if you’re looking to minimize your overall tax burden, don’t forget about state taxes. For instance, my home state of Pennsylvania doesn’t tax retirement account withdrawals, but it does tax capital gains.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Victims of the VirusRefi or Not and Working the Numbers. Follow Rick on Twitter @RConnor609.

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