The Impact of Capital Gains

By Hightower Westchester on September 6, 2022

As an investor, you likely know what capital gains are on a high level. The term capital gain refers to the increase in the value of a capital asset when it is sold. In other words, a capital gain occurs when you sell an asset for more than what you originally paid for it. That can include almost any type of asset you own, whether it’s a type of investment (like a stock, bond, or real estate) or something purchased for personal use (like a home or a boat).

You likely also know that there are both long-term capital gains (gains on assets held for over one year) and short-term capital gains (gains on assets held for less than one year), and that both are taxed differently. Long-term capital gains are taxed at a lower rate than short-term capital gains as well as ordinary income taxes.

What may not be as obvious is whether realizing these gains will cause your wages or IRA withdrawals to be taxed at a higher rate? Understanding these nuances of the tax code can be difficult, so we wanted to put together a piece to help you better understand capital gains when the time comes.

As much as none of us like to pay taxes, there are several reasons one would take capital gains. Maybe you’re planning to make a large purchase, coordinating retirement withdrawals, or you’re between tax brackets. Whatever the reason to take those capital gains is, it’s important to understand how it affects your tax burden.

Let’s start with the elephant in the room, do capital gains increase your adjusted gross income (“AGI”)? The answer is yes. As your AGI increases, you begin to get phased out of itemized deductions, certain tax credits, and lose your eligibility for Roth IRA or deductible IRA contributions.

One of the biggest misconceptions of capital gains is around tax brackets. Long-term capital gains are taxed separately from your ordinary income, while your ordinary income is taxed first. In other words, long-term capital gains and dividends, which are taxed at the lower rates, will not, I repeat, will not, push your ordinary income into a higher tax bracket! The important part is whether the gains are short or long-term. Short-term gains are included in your ordinary income and therefore taxed at your ordinary income rate. However, long-term gains receive a lower, preferential tax rate.

The tax code is filled with loopholes and quirks. One example of this as it relates to capital gains, is the 0% tax rate on long-term capital gains. No, that is not a typo. Starting in 2018 and until (at least) 2025, the long-term capital gains tax is 0% if the seller is roughly in the 12% ordinary income tax bracket (which equates to married couples with a combined salary of $83,550 or single filers with an income of $41,775).¹ And if part of that long-term gain is realized in the 12% bracket and crosses over into the 22% bracket (above $83,550 for married couples filing jointly or above $41,775 for single filers), everything up to the 22% threshold is taxed at 0%, while only the amount above the 22% will be taxed at the higher marginal rate of 15%.² And remember, your ordinary income remains in the 12% bracket.

Notably, though, long-term capital gains rates are still graduated tax rates, akin to the ordinary income tax system. Which means just landing in the 0% long-term capital gains tax bracket doesn’t give the opportunity for “unlimited” long-term capital gains at 0%. While the tax rate may be 0%, capital gains are still income, and would eventually push the individual out of the 0% capital gains bracket and into higher brackets (note – not ordinary income tax brackets).

Here is a good example of just that. Let’s say you are a single taxpayer and are considering whether to take a $100,000 distribution from your IRA (all ordinary income) or liquidate $100,000 of zero-basis stock (all capital gains).

If you take the $100,000 from your IRA, the income will span across the 10%, 12%, and 22% tax brackets, resulting in a tax bill of 10% x $10,275 + 12% x $31,500 + 22% x $47,300 + 24% x $10,925 = $17,835 in total taxes, for a blended effective tax rate of about 17.8%.

By contrast, if you took a $100,000 long-term capital gain this year, and are in the bottom tax bracket, you are eligible for the 0% long-term capital gains rate. However, the 0% rate similarly only extends up to $41,775 of income (for a single taxpayer), beyond which the 15% capital gains bracket kicks in.

As a result, you will owe $8,733 in long-term capital gains taxes, which includes 0% on the first $41,775 of long-term capital gains, and 15% on the last $58,225 of long-term capital gains, for a blended effective tax rate of 8.7%.

The end result is that, just like the ordinary income tax system, long-term capital gains will typically end up being taxed at a blend of multiple tax brackets (https://www.irs.gov/taxtopics/tc409). Though at the margin, planning for the next dollar of income or deductions will still be based on the current marginal tax bracket (for ordinary income or long-term capital gains).

In the end, you may still have some questions about how capital gains are taxed compared to ordinary income. It is important to consult your tax preparer/CPA to get a better understanding of your circumstances and to see if any of these planning tips make sense for you.

Richard Flahive – Private Wealth Advisor and Director of Research & Planning – Hightower Westchester

914.825.8639 – rflahive@hightoweradvisors.com

Sources –

¹https://www.forbes.com/advisor/taxes/taxes-federal-income-tax-bracket/

²https://www.irs.gov/taxtopics/tc409#:~:text=The%20tax%20rate%20on%20most,or%20qualifying%20widow(er).