Long term capital gains (LTCGs) tax is one of the most common tax planning items you’ll have to account for, yet is also the most misunderstood. This short explainer will give you a high level overview of federal tax calculations and show you how LTCGs is applied. Before we jump into a few examples, let’s quickly define a few key topics:
Taxable Income: This is how much of your income is subject to taxation after some deductions. In a very brief way, you arrive at this number in the following order:
Gross income
(-) adjustments
= Adjusted Gross Income (AGI)
(-) standard deduction or itemized deductions
= Taxable Income
Federal income taxes: Marginal tax rates begin at 10% and climb to 37% at the highest rate. You pay tax based on your taxable income using these marginal rates, shown in Table 1. Ordinary income (such as your wages) and short term capital gains (such as your stock investments sold less than a year after purchase) are subject to these rates.
Long term capital gains taxes (for stocks): There are 3 marginal rates: 0%, 15%, 20%. The rates are applied to investments sold after holding them for more than a year (or qualified dividends). How much you pay is also based on taxable income, but not considered until you factor in ordinary and short term capital gain taxable income. Visually speaking, your LTCGs are ‘layered on top’ of your ordinary and short term capital gain income.
To illustrate how LTCGs tax works, it’s best to first figure your taxable income WITHOUT considering your LTCGs. You can easily calculate what marginal rate you will pay on your LTCGs once that number is figured. The following two examples cover how the rate is applied. Let’s jump into some examples!
Case 1
George and Martha Washington file their taxes Married filing jointly and have taxable income of $75,000 of which $25,000 is due to LTCGs. Their $50,000 in taxable income due to their wages is calculated using the federal income tax rates in Table 1 and totals $5,589 ($20,550 taxed in the 10% bracket and the remaining taxed in the 12% bracket). Their LTCGs tax rates are calculated by first comparing their non-LTCG taxable income number ($50,000) to the LTCG tax table for MFJ filers. As shown in Table 2, the 0% bracket begins at $0 in taxable income and goes all the way up to $83,350 in taxable income. Without factoring in any LTCGs, they are in the 0% bracket. This means they can realize up to $33,350 ($83,350 – $50,000 in taxable income w/o considering LTCGs) in LTCGs and pay 0% on their gains. George and Martha have $25,000 in LTCGs and accordingly will pay 0% or $0 on their gains. In fact, they can realize an additional $8,350 in LTCGs to fully realize $0 in LTCG taxes.
Case 2
Same case as #1, except we are increasing the Washington’s taxable income w/o considering LTCGs to $75,000 and increasing their LTCGs to $50,000. In this scenario, you would pay $8,589 in federal income tax due to non-LTCGs ($20,550 taxed in the 10% bracket and the remaining taxed in the 12% bracket). Their LTCGs tax is calculated by first comparing their their non-LTCG taxable income ($75,000) to the LTCG tax rates for MFJ filers. As shown in Table 2, they’re still in the 0% bracket ($75,000), but by adding in their LTCGs ($50,000), they move into the 15% bracket ($125,000 is in the 15% bracket). This means their $50,000 in LTCGs will be partially taxed at 0% with the remaining taxed at 15%. The amount taxed at 0% ($8,350) will be the difference between the top 0% bracket ($83,350) and taxable income w/o considering LTCGs ($75,000). The remaining amount ($41,650) is taxed at 15% to bring their LTCG tax owed to $6,284 and total tax bill to $14,837.
Other Important Items To Consider
The 15% LTCG bracket covers A LOT of income: Most families fall into this bracket when dealing with LTCGs tax planning. Are you waiting to sell your investments to avoid paying tax? Is there going to be an opportunity where you would be in the 0% bracket?
State Taxes: You should consider state taxes as well. States like CA do not have LTCG tax rates and tax all income at state income tax rates. Are you moving to another state in the future with 0% income tax brackets?
LTCGs includes qualified dividends: I use LTCGs as the verbiage above, but this does include qualified dividends. Not ordinary dividends, but qualified dividends.
Net Investment Income Tax: There’s an additional layer of tax that comes into play when you have a larger amount of investment income: the net investment income tax or NIIT. The NIIT is a 3.8% tax on investment income such as capital gains, dividends, and rental property income. This tax only applies to high-income taxpayers, such as single filers who make more than $200,000 and married couples who make more than $250,000. The net investment income tax is due on the lesser of your net investment income or the portion of your modified adjusted gross income (MAGI) that exceeds the thresholds. Multiply the lower number by 0.038 (3.8%). This is the amount of net investment income tax you will pay. You’re only subject to this tax if you have net investment income AND your MAGI exceeds these thresholds. MAGI DOES include LTCGs and qualified dividends.
Retirement Accounts: You DO NOT pay LTCGs tax in retirement accounts. All of your gains are deferred in these accounts, regardless of long or short term holding periods. Capital gains are only realized from buying and selling your stock in your non-retirement accounts. Also called your brokerage accounts, individual accounts, or your Robinhood accounts (as of writing this, Robinhood doesn’t allow you to open retirement accounts).
Tax shouldn’t be the only consideration: Don’t let tax be the only reason you’re holding onto your investments. As mentioned above, the 15% bracket for LTCGs covers a lot of taxable income and begins at a relatively lower marginal rate. Do you REALLY think there’s going to be an opportunity for you to be in those 0% brackets? If not, there’s no tax reason to hold onto your investment if you’re wanting to ditch the investment purely based on performance.
Putting it all together
Ultimately, your taxable income will drive the rates you pay with your LTCGs. Make sure you’re planning carefully and taking into consideration all of the items above. I hope you’ve found this helpful and I’ll see you out there!
