Capital Gains Tax: The Inner Workings
Most investors are aware of or have dealt with the capital gains tax, but lack a firm understanding of how they impact your overall taxes. For starters, long term capital gains are tiered and fall into one of three brackets:
In addition to the tiers above, there is also an additional 3.8% medicare surcharge for individuals whose adjusted gross income (AGI) is $200,000 or greater, or for married couples with AGIs above $250,000. The surcharge impacts a portion of the long term capital gains in the 15% bracket and all of the gains that fall into the 20% bracket.
How is my Long Term Capital Gains Rate Calculated?
The rate you pay on Long Term Capital Gains is driven by your ordinary income for the year in which you sell. A security must be held for at least one year and one day in order to qualify for long term capital gains treatment. Any security held under a year is considered ordinary income and taxed as such.
A breakdown of the income tax and capital gains brackets can be found in this 2020 diagram by Michael Kitces:
A quick glance at the diagram highlights the beneficial tax treatment that long term capital gains receives in comparison to ordinary income.
Do Capital Gains Affect My Marginal Tax Bracket?
The tax code can cause anyone a headache, but presents a number of planning opportunities for those who understand and coordinate their income and capital gains, especially as they approach retirement or experience lower income for a period of time.
Long term capital gains will increase your AGI for the year. A higher AGI can affect
- Your ability to qualify for a number or tax credits
- Limit your ability to itemize deductions
- Impact your eligibility to make a deductible contribution to an IRA
- Impact your eligibility to contribute to a Roth IRA
However, It is important to understand that long term capital gains stack on top of ordinary income. This means that ordinary income is taxed first and that long term capital gains realized during the year will not push you into a higher marginal bracket.In layman’s terms, realizing long term capital gains will not cause your income to be taxed at a higher rate.
We can take a look at some planning opportunities that are available now that we understand exactly how the capital gains tax works and the impact it has on our personal tax situation.
It is possible to pay 0% tax on capital gains. Say what! Depending on your income for the year there is the potential for you to pay no tax on a portion of your realized capital gains. If your income for the year falls in the 10% bracket and a portion of the 12% bracket, any gains realized during that year will be taxed at 0% under the current tax code (which is set to expire in 2025). Additionally, if part of the gain recognized in the 12% bracket extends into the 22% bracket, everything up to the 22% limit is also taxed at 0%. This applies to:
- Individual filers with an income of approximately $40,400
- Married couples with an income of approximately $80,800
Let’s review a high level example to bring the details to life. Say you are a married couple with income of $70,800 for the year and you realize $15,000 in long term capital gains:
- $10,000 of the gains will not be taxed
- $5,000 of the gains will be taxed at the 15% rate
- Ordinary income remains in the 12% bracket
A 0% capital gains tax can help you keep your overall tax burden down before and during retirement, and can also provide an excellent opportunity to slightly diversify a concentrated holding with minimal tax impact!
When It Makes Sense to Forego the 0% Tax
“Never” is the answer most of you are telling yourself as you read the heading. Who in their right mind would willingly forego the option of not paying tax? I would be inclined to agree with you in most instances, however there are specific situations where using Roth conversions in low income years can actually help you avoid higher taxes in the future.
Roth IRA conversions can be a powerful long term planning tool, especially for those in their “gap” years. Gap years are the period of time when you are retired and aren’t subject to RMDs. The strategies implemented during this brief window can have a beneficial impact on your overall tax liability in retirement. Roth IRA conversions consist of converting pre-tax IRA funds into a Roth IRA. The benefits of a Roth IRA include:
- No RMD requirements
- Assets are allowed to grow tax free
- Distributions from a Roth are also tax free
The catch: any funds converted from the pre-tax IRA to the Roth IRA are taxed as income in the year of the conversion. So, how do you know if a Roth conversion is the right strategy for you? Your goal should be to pay taxes at the lowest rate. If you are :
- In your gap years
- Are a sales professional and experienced an off year
- Started a business
Using Roth conversions in these situations allows you to pay taxes now at a lower rate than is anticipated in the future! Additionally, the account should have enough time to accumulate and grow in order to make up for the up front tax hit that was experienced during the conversion. Multi-year planning can help coordinate Roth conversions and capital gains to limit your overall tax liability in retirement.
RMDs and Income Requirements in Retirement
Another consideration for those preparing for retirement is their current projected RMD obligations. If your RMDs provide more income than you need to live on during retirement, a Roth conversion strategy in your gap years can reduce your pre-tax IRA value and the distributions you are required to take beginning at age 72 (also lowering the amount of income you are forced to recognize each year). A detailed cash flow and expense analysis, as well as a future tax rate projection can help you determine your needs and how your RMDs fit into the equation. Filling up the 10% and 12% bracket during low income years will eliminate the 0% tax on capital gains, but can provide an opportunity to pay lower taxes on funds that can accumulate and be withdrawn tax free in the future. The pay off may trump the 0% capital gains tax in the long run!
The Big Picture
- Capital gains taxes are calculated after ordinary income. They don’t impact the taxes you pay on your income during the year.
- Capital gains will impact your AGI
- 0% capital gains are a real thing (for now).
- In certain instances it may make sense to forego the 0% capital gains tax and implement a Roth conversion strategy
Disclaimer: The information on this site is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This information should not be relied upon as the sole factor in an investment making decision. This content is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Hereford Financial disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose.