Dec 20, 2022
Myth busted: “Capital gains pushed me into a higher tax bracket!”
As people review their tax returns, they may see long-term capital gains or qualified dividends that increase their total income. This may lead them to conclude that this extra income has forced them into a higher tax bracket.
However, this is rarely the case. To understand why, let’s take a look at how your taxes are actually prepared.
Two tax lanes
Portfolio income is sometimes taxed at lower rates than ordinary income like wages, retirement withdrawals and business income. This table compares the differences:
The myth of being pushed into a higher tax bracket arises from a misunderstanding of how the capital gains and ordinary income tax rates interact with one another.
How taxes are made
Here is a simplified version of the interplay between the two tax lanes:
- Step 1: Take the total of your ordinary income.
- Step 2: Subtract your deductions to get the amount that is taxed at ordinary tax rates. This amount will be taxed progressively, with the lower amounts taxed at lower rates and higher amounts at higher rates.
- Step 3: Add your long-term capital gains to the amount in step 2. This will help determine the tax rate on your capital gains.
The very fact that capital gains are added on top of net ordinary income shows that they cannot push you into a higher ordinary tax bracket! The number that you arrive at in step 2, however, may push you from the 0% to the 15% or 20% capital gains tax 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*These figures are for illustrative purposes and are outdated.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.
Keep in mind that this is not a comprehensive analysis. The tax code is dense and includes numerous exceptions, plus meaningful “shadow” taxes that can be applied (like Medicare surcharges and net investment income tax), that must be considered.
Nonetheless, when you work with your wealth advisor and tax professional to look at the interplay between these taxes over decades of your financial plan, it’s possible that you will uncover some myths and even potentially some meaningful tax savings.
