Can Capital Gains Push Me Into a Higher Tax Bracket? — Phillip James Financial (2024)

What are capital gains and how are they taxed?

A capital gain refers to the increase in value of an asset such as stocks, bonds, precious metals, real estate, and other assets. When these assets are sold, the realized gains are taxed at lower rates than ordinary income if the assets are held for at least one year. If the assets are held for less than a year, the gain is treated as a short-term capital gain which is taxed under ordinary income tax rates.

Capital gains are taxed at rates favorable to ordinary income rates for a number of reasons. One of those reasons is to encourage individuals to invest in corporations and real estate, as these investments tend to benefit society and drive economic growth. Secondly, having lower capital gains tax rates encourages individuals to realize gains when timing is appropriate as opposed to holding onto these assets longer than they otherwise would have, which causes current tax revenues to increase. Finally, the taxes collected for capital gains is a tax on assets which were taxed previously at another level. Earnings for a corporation, for example, are taxed at the corporate level and then investors are again taxed on the change in value of shares of stock in the corporation when those gains are realized.

The long-term capital gains tax rate is 0%, 15%, or 20% depending on the individual’s taxable income and filing status. For a single filer in 2021, the capital gains tax rate is 0% for income up to $40,400, 15% for income above $40,400 but below $445,850, and 20% for any income above $445,850. For individuals earning $250,000 or more if married and $200,000 or more for single filers, an additional 3.8% tax is levied on capital gains. Ordinary income tax rates for a single filer in 2021 range from 10% at the lower income levels to 37% for income levels above $523,600.

While increases in asset values are generally qualified to be taxed at the long-term capital gains rates, there are exceptions for collectible assets such as coins, precious metals, antiques, and fine art which are taxed at a higher rate of 28%.

How is the capital gains tax liability calculated?

To determine an individual’s capital gains tax liability, the period in which the asset was held prior to the sale should first be reviewed. If the asset was held for longer than one year, then long-term capital gains tax treatment applies. The combined income an individual earned between ordinary income and the capital gain is used to determine the long-term capital gains rate that the individual will be taxed on. For example, if an individual earned $60,000 in ordinary income and has a capital gain of $20,000, this total income of $80,000 will be used to determine the tax amount owed on the capital gain.

A single filer pays a 0% long-term capital gains tax rate if total income is $40,400 or less between ordinary income and the capital gain amount. If ordinary income is below $40,400 and the capital gain pushes the total income above this level, then part of the capital gain will be tax free while part will be taxed at the next progressive bracket level of 15%.

For the 2021 tax year, John has ordinary income of $35,000. He plans to sell stock from his brokerage account in 2021 that he has held for 5 years which will provide him with a $15,000 long-term gain. Since John’s ordinary income is below $40,400, part of his capital gain will be tax free while the remaining gain that pushes his total income above $40,400 will be applied with a 15% tax rate. In this case, $5,400 of the $15,000 will be tax free while John will owe 15% of the remaining $9,600 gain, or $1,440. This equates to a net capital gains tax rate of 9.6% ($1,440 / $15,000).

The example above illustrates that the long-term capital gains rates are quite advantageous in comparison to ordinary income tax rates. For this reason, it is always recommended that assets be held a minimum of one year prior to realizing a gain if possible. An effective tax planning strategy can also allow individuals to recognize gains during years when ordinary income may be at lower levels which allows the long-term capital gains to be taxed at lower rates. Examples of this could be transition years between jobs, retirement, or other periods of time when ordinary income is less for various reasons. Losses in value on assets can be recognized to offset gains, so losses can also be strategically recognized in parallel with gains to minimize tax liability.

Can my capital gains push me into a higher tax bracket?

An individual’s ordinary income level has an impact on the tax rate that is applied for long-term capital gains. However, the reverse does not apply and the amount of capital gains recognized in a given year does not impact an individual’s ordinary income tax bracket. If an individual has $60,000 of ordinary income in a given year, this ordinary income amount will be taxed in the same tax bracket regardless of whether this individual recognized zero in capital gains during the year or $1M in capital gains.

Although the specific ordinary income tax bracket is not impacted by realized capital gains, the Adjusted Gross Income (AGI) amount is impacted by both ordinary income as well as capital gains. This is important to understand, as the level of AGI an individual has impacts a taxpayer in several areas including deductions, credits, and whether Roth IRA contributions are permitted.

Steve is a single filer with a Modified Adjusted Gross Income (MAGI) level of $120,000 in 2021. Steve has stock that he would like to sell which will provide him with a long-term capital gain of $30,000. If Steve proceeds with this sale, the tax Steve owes on his ordinary income will not be impacted, and a total of 15% or $4,500 in tax will be owed on the $30,000 capital gain. Although there is no impact to Steve’s tax liability on his ordinary income as a result of realizing the capital gain, he now no longer qualifies to contribute to a Roth IRA in 2021 and may see additional impacts to qualifications for various deductions and credits.

Long-term capital gains are taxed at rates which are favorable to ordinary income tax rates, and the level of long-term capital gains realized in a given year does not impact an individual’s tax rates on ordinary income. Effective tax planning can allow an individual to minimize tax burden while avoiding a potential unfavorable impact to other qualifying deductions and credits.