Most of us know that taxes on capital gains are more favorable than other types of taxable income. For “ordinary income”, the tax brackets have rates of 0%, 12%, 22%, 24%, 32%, 35% and 37%. Ordinary income is comprised of things like wages, interest income, and IRA distributions, among other things.
To contrast, capital gain rates are 0%, 15% or 20%. As I discuss this tax, I will add another closely-related tax, that on net investment income (“NII”) which is 3.8% for high earners. In general, you can see that capital gain rates (0%-to-20%) are lower than ordinary income rates (0%-to-37%).
Below I explore the various capital gains rates, including the effect of the NII tax. Technically the Internal Revenue Code does not have capital gain rates of 18.8% and 23.8% (discussed below). I use them to illustrate that simply using 15% and 20% rates ignores the very real NII tax. Let’s assume capital gains are from sales of marketable securities or mutual funds.
Short-Term Capital Gains. These are taxed at your ordinary income tax rate. No tax break on sales of assets that you hold less than one (1) year. Use ordinary tax rates and you might add the 3.8% NII tax if your other income is high enough.
Long-Term Capital Gains.
- 0% bracket. If your taxable income, including the capital gain, is under $38,600 (single) and $77,200 (married joint), your capital gain is not taxed. If your taxable income is below these levels, consider taking in some gains and pay no federal tax!
- 15% bracket. Most people with gain/loss activity fall into this category.
- 18.7% bracket. Here comes this stealth NII tax at 3.8%. If you pay both the capital gains tax (15%) and the NII tax (3.8%), you are really paying 18.8%. NII tax applies to people with Modified Adjusted Gross Income (“MAGI”) over $200,000 (single) and $250,000 (married joint). The confusion starts at this point: [a] Capital gains rates are based on taxable income vs. [b] NII tax is based on MAGI. No, they don’t make things easy.
- 20% bracket. Practically speaking, this is fiction. If 20% applies to you, then 3.8% applies to you almost every time. Let’s move straight to the 23.8%.
- 23.8% bracket. When your taxable income exceeds $425,000 (single) and $479,000 (married joint), your capital gain rate is 20% and the 3.8% add-on is inevitable.
Note: You will get benefit of the lower brackets if they apply to your situation. For example, if you had no ordinary income but a $1,000,000 capital gain, you will still get benefit of the 0% bracket, then the 15% bracket, then 18.8% bracket with the remainder taxed at 23.8%. On the other hand, if you are starting with wages of $479,000+ (or any type of ordinary income) and have capital gains, you will start at 23.8% and none of the lower cap gain rates will apply.
Capital Gains-Related Topics
- Qualified Dividends. Dividends from stocks and mutual funds can be “qualified” or “nonqualified”. They are identified in your year-end tax statements from your brokerage company (e.g., TD Ameritrade, Schwab, etc.) Qualified dividends are taxed at the same rates at long-term capital gains (0%-15%-18.8%-23.8% rates).
- State taxes. (I hear “boo” out there from the California contingent.) Treatment of capital gains vary from state-to-state. California makes no distinction between ordinary income and capital gains. Rates go from 1%-to-13.3%. Many people can have no federal tax on a capital gain and still incur state income taxes on the same gain.
We cannot blame the Trump administration for this seemingly crazy scenario as the recent tax bill left capital gains unchanged. The Bush Administration had a 0%-15% rate structure, then the Obama Administration added the 20% bracket (now 3 tiers) and invented the 3.8% NII tax.
Tax planning around capital gains can be confusing. Inspired Financial looks for opportunities at each of the break points to minimize taxes and to grow their investments with tax-efficiency.
Please consult with your tax advisor before implementing any tax strategy. The above is intended for general information and is not providing advice to your specific tax situation.
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