Continuing with the theme of tax planning and how to bring down what you owe Uncle Sam, I’m going to cover a common question I get: Will capital gains push me into a higher tax bracket?
This podcast episode was originally published Nov 6, 2019. These show notes have been updated Oct 4, 2023 to reflect 2023 income brackets and to include additional content and a YouTube video.
Listen to Episode 9 Here:
How Capital Gains Affect Taxes
I apologize for the numbers and percentages that are about to follow, but I simply can’t avoid it when discussing tax planning.
The difference between income tax and capital gains tax rates
First, it’s important to distinguish between our 7-bracket, ordinary income tax rates and our lower 3-bracket capital gains and qualified dividends tax rates, which I have discussed before, but let’s revisit this distinction.
Let’s go over the lower, ordinary income tax rate brackets for 2023.
If you are filing as an individual and earning up to $11,000 this year, or if you are married and filing jointly, and earning up to $22,000 this year, you will be in the lowest ordinary income tax bracket, which is 10%.
And if you are filing as an individual and earning over $11,000 and up to $44,725, or if you are married and filing jointly, and earning over $22,000 and up to $89,450 this year, you will be in the 12% ordinary income tax bracket.
Now, the 12% ordinary income tax bracket, which is of course in the higher, 7-bracket rates in the U.S., closely coincides with the 0% bracket in the lower, 3-bracket system for capital gains and qualified dividends.
What does that mean? Well, it means you are married filing jointly and have about $90,000 in income, excluding any deductions, you would pay 12% in taxes if it was ordinary income but, if it were long-term capital gains or preferred dividends, you would pay zero taxes! So, obviously the 3-bracket rates are much preferred over the ordinary income tax rates, right.
And I know I rounded up to $90,000 for simplicity sakes, but to clarify, the capital gains rate threshold for 2023 is $44,625 for individuals and $89,250 for married filing jointly, so there’s a $100 difference between the thresholds for individuals and a $200 difference for couples.
As a little FYI, the 15% capital gains, tax rate bracket is fairly large. It goes from $44,626 to $492,300 for individuals, and from $89,451 to $553,850 for married couples, so it’s a big bracket. And anything over those amounts is taxed at 20%. So, definitely preferred to what would be either the 35 or 37% bracket if you had ordinary income that high.
Now, as I mentioned, in 2023, if you are single and earn $44,625 or below or married and earn $89,250 or below, you could pay $0 taxes on your long-term capital gains up to each of those respective thresholds.
If you reach and go over those respective thresholds, (into the 15% capital gains bracket), the long-term gains in the lower bracket are still taxed at 0%, but anything over that rate will be taxed at the 15% capital gains rate.
And if you have ordinary income, all of the capital gains and qualified dividend income, and respective tax brackets, will stack on top of that ordinary income.
Well, what the heck does that mean? Clear as mud, right?
Here's a table to help!
|Federal Income Tax Brackets||Long-term Capital Gains Tax Brackets|
|Single Filers||Married Filing Jointly||Tax Rate||Single Filers||Married Filing Jointly||Tax Rate*|
|$0 - $11,000||0 - $22,000||10%||$0 - $44,625||$0 - $89,250||0%|
|$11,001- $44,725||$22,001 - $89,450||12%||$44,626 - $492,300||$89,251 - $553,850||15%|
|$44,726 - $95,375||$89,451 - $190,750||22%||$492,301 or more||$553,851 or more||20%|
|$95,376 - $182,100||$190,751 - $364,200||24%||* short-term capital gains are taxed at ordinary income tax rates|
|$182,101 - $231,250||$364,201 - $462,500||32%|
|$231,251 - $578,125||$462,501- $693,750||35%|
|$578,126 or more||$693, 751 or more||37%|
An example showing how capital gains are taxed
Let me give you an example. Ignoring any credits or deductions, let’s say you are married and have a combined income of $60,000, and you also have long-term capital gains of $40,000, so you have $100,000 of total income. But, different income types, get taxed different ways.
First, the $60,000 will be taxed at the 7-bracket, ordinary income tax rates.
But, the question was, will the $40,000 in capital gains, push me into a higher tax bracket? Well, the answer is yes, but only in the preferred, 3-bracket, lower rate system, consisting of capital gains and qualified dividends.
So, continuing with the example, of the $40,000 in capital gains, $29,250, or $89,250 threshold, minus 60,000 which = $29,250, that will be taxed at the 0%, long-term capital gains and qualified rate, and $10,750 (40,000-29,250) will be taxed at the 15%, capital gains rate.
So, again, back to the main question: Will capital gains push you into a higher tax bracket?
So, will capital gains push me into a higher tax bracket?
Capital gains will NOT cause your ordinary income to be taxed at a higher rate. So, this is obviously good.
But, capital gains will increase your adjusted gross income (AGI), and this can cause you to lose eligibility to contribute to an IRA or a Roth IRA, and you could be phased out of itemized deductions and some tax credits.
So, again, long-term capital gains are taxed at different rates and separately from your ordinary income.
Your ordinary income is taxed first, at its higher relative tax rates, and long-term capital gains and dividends are taxed second, at their lower rates.
So, long-term capital gains can’t push your ordinary income into a higher tax bracket, but they may push your capital gains rate into a higher tax bracket.
It is also very important to distinguish between short-term and long-term capital gains, since short-term gains are taxed at the same, higher rates as your ordinary income, and long-term gains are taxed at the preferred, lower rates.
Again, knowing the tax code, and associated financial tools, can lead to many tax planning opportunities to lower what you pay Uncle Sam!