A common misconception I frequently hear is that capital gains pushed the taxpayer into a higher tax bracket.
What is happening?
As people are reviewing their tax returns, they may see long-term capital gains or qualified dividends that increases their total income. Subsequently, they may conclude that since they had that additional income, that it is forcing them into a higher tax bracket —22%, 24%, 32%, 35% or 37% ORDINARY tax brackets.
This assumption is not necessarily the situation. Let’s take a look at how your taxes are actually prepared.
Two Tax Lanes
Many of us know that portfolio income sometimes is taxed at lower rates than ordinary income (wages, retirement withdrawals, business income).
The disconnect arises when we misunderstand how the capital gains and ordinary income tax rates interact with one another.
How Taxes are Made
Here is my simplified version of the interplay between the two tax lanes:
- Step 1: Take total of your ordinary income.
- Step 2: Subtract all deductions against your ordinary income to get what is taxed at the ordinary tax rates. This amount will be taxed progressively. The lower amounts taxed at lower rates which increase as the income moves through the higher brackets.
- Step 3: Add your long-term capital gains to step two, this number will help determine the capital gains rates that the portfolio income will be taxed at. The very fact that this comes after step two, means that you cannot have your qualified portfolio income push you into higher ordinary tax brackets! The number that you arrive at in step 2, however, may push you from the 0% to the 15% or 20% capital gains bracket.
*These figures are for illustrative purposes and are outdated, for example there are no personal exemptions at this time though the principals remain the same. The visuals in this article have been sourced from Kitces.com
I am not suggesting anyone do this for themselves. The tax code is dense and includes numerous exceptions (which is for another day). I also am not suggesting that these are the only pieces to evaluate, because there are other meaningful ~shadow~ taxes that can be applied (like Medicare surcharges, Net Investment income tax, etc.) which we would be remiss if we didn’t consider.
We love to explore these quirks. When we work with our clients and look at the interplay between these taxes over decades of their financial plan, we sometimes find potential meaningful tax savings that we get excited about. We regularly produce tax reports and projections to show our clients where they are in each of these lanes and where they may be in the future.
If any of these pieces are not being considered as part of your tax planning, then you might be paying Uncle Sam more than you need to. Reach out to me if you would like to talk about how we incorporate tax planning into your financial plan to help reduce your taxes and then focus on what matters to you.
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