This week we will continue with the theme of tax planning. I’m going to cover a listener question: Will capital gains push me into a higher tax bracket? Then I will give some thoughts on the financial advice industry as a whole.
Listen to Episode 9 Here
Taxes Are Certain
— Benjamin Franklin (he wrote that in a letter in 1789)
Franklin’s use of this idiom in his letter is not the first written use of the famous quote that “nothing is certain except death and taxes,” but I’m a fan of Franklin, so I chose his quote.
On that note, we are continuing the *exciting* theme of tax planning. (As a reminder, last week we talked about reducing taxes using Roth IRA conversions.)
I obviously say that in jest. Taxes are not fun, but they are necessary, and knowing how to navigate the rules properly, and using proper tools, can literally save you sometimes thousands of dollars immediately and tens of thousands, if not millions, of dollars over the long haul!
How Capital Gains Affect Taxes
I want to cover a recent listener question: Will capital gains push me into a higher tax bracket?
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 income tax rates and the lower capital gains and qualified dividends tax rates.
Let’s go over the 2019 lower bracket income tax rates. Individuals earning up to $9,700 and married couples earning up to $19,400 are in the 10% tax bracket. And individuals earning over $9,700 up to $39,475 and married couples earning up to $78,950 are in the 12% tax bracket.
The 12% income tax bracket closely coincides with the 15% tax bracket on capital gains and the qualified dividend rate.
The capital gains rate threshold is $39,375 for individuals and $78,750 for married couples, so there’s a $100 difference in thresholds for individuals and a couple hundred-dollar difference for couples.
As a little FYI, the 15% capital gains tax rate bracket is fairly large. It goes from $39,375 to $434,550 for individuals and from $78,750 to $488,850 for married couples, so it’s a big bracket. And anything over those amounts is taxed at 20%.
In 2019, if you are single and earn $39,375 or below or married and earn $78,750 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.
Clear as mud, right?
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 have long-term capital gains of $40,000. Of this $40,000, $18,750 (78,750-60,000) would be taxed at the 0% long-term capital gains rate, and $21,250 (40,000-18,750) would be taxed at the 15% capital gains rate.
Now, back to the main question: Will capital gains push you into a higher tax bracket?
Realizing capital gains will not cause your ordinary income to be taxed at a higher rate. This is obviously good.
What capital gains will do is 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 lower rates.
Again, knowing the tax code and associated financial tools can lead to many tax planning opportunities with your capital gains.
The Financial Advice Industry
Now I want to discuss financial advisors, in general.
I was having dinner the other night with friends and family, and the topic of financial advisors came up, and someone mentioned that financial advisors are all selling and trying to do the exact same things for clients. While I understand most people outside the financial planning and investment management field think this, this is not the case.
The barriers to entry for the financial advising industry are relatively low. And sometimes people who call themselves advisors aren’t actually advisors. They may just sell financial products like insurance, annuities, mutual funds or the next hot stock tip, but this doesn’t make them advisors. It makes them sales people.
I’m not saying there isn’t a need for these agents; I just believe they should clearly explain what they’re going to do for you and how they are going to get compensated.
I tell people I don’t sell anything; I simply analyze their situation and give them recommendations and they choose how to move forward.
Michael Kitces (a key voice in the planning community) states the following:
“Most of the harms inflicted on consumers by “financial advisors” occur not due to malice or greed but ignorance; as a result, better consumer protections require not only a fiduciary standard for advice, but a higher standard for competency.
The CFP should be the minimum standard for financial planning, but there is room for post-CFP studies/designations, especially those that support niches and specialization.”
As I’ve mentioned before, if you’re looking for an advisor, look for a fee-only fiduciary CFP®. Make sure they are required to put your interests ahead of their own!
And, yes, ERWA is a fee-only, fiduciary firm, and, yes, I’m a CFP®.