Trying to understand taxation of investments, need a clue.
As one’s taxable income rises, the incremental amounts of income are subjected to higher and higher tax rates - but those elevated tax rates don’t apply to the first increments of income. So if I have $200,000 in taxable income for 2016, and the married-filing-jointly tax rates look like this, then I pay 28% tax only on the last ~$48K of income; the rest of it is taxed at lower rates.
So what’s the scoop on taxation of dividends and capital gains? On the bottom of this page, they list tax rates on qualified dividends and long-term capital gains as a function of taxable income.
Question: is the dividend/capgain tax rate progressive, like income tax, or is it a simple flat tax rate for all your gains?
Example: if I have $100,000 in taxable income, and $10,000 in cap gains, is all of my cap gains taxed at 15%, or is part of it taxed at 0%?
LTCG / Qual Div is also progressive, but with fewer steps, it just goes 0-15%-20%, see table here:
And don’t forget that 3.8% Net Investment Income Tax kicks in at higher levels of AGI too. This applies to all unearned income, including all dividends whether qualified or not and all cap gains whether ST or LT.
While the Qualified Dividend and Capital Gains worksheet is a bit of a doozy to go through if you don’t know why you’re doing it, here’s an easy way to think about it.
QD/LTCG that would be taxed at 10% or 15% if it were ordinary income is instead taxed at 0%. QD/LTCG that would be taxed at a higher rate than that but not at the top tax rate (39.6%) is instead taxed at 15%. QD/LTCG that would be taxed at the top rate is taxed at 20%.
So there are 2 breakpoints instead of 6 or 7 or however many there are for ordinary income, and these 2 correspond precisely with 2 breakpoints for ordinary income.
You first calculate your tax on ordinary income, $90,000 in this case. Let’s say that puts you in the 25% bracket. Then your $10,000 in capital gains is taxed at 15%.
To illustrate more how it works, let’s say the 15% bracket ends at $50,000 for you, and you have $45,000 in ordinary income and $15,000 in capital gain. Then the first $5,000 of your capital gains would be taxed at 0%, as that is how much more ordinary income you could have that would still be taxed at 15%. Then the other $10,000 is taxed at 15%.
There’s no actual difference in the order you take the income if you stay within the 25% bracket, as taking the capital gain at 0% first (instead of having it taxed at 15%) would push an equal amount of income up from 10% to 25%. If you’re in higher brackets, it’s definitely to your advantage to take the capital gains last.
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To complicate things more, there are 2 further classes of capital gains that don’t use those lower rates.
“Unrecaptured Section 1250 gain”, which is basically depreciation recapture on real estate, is taxed at a maximum of 25%. So if you owned a rental home you depreciated many years and sold it for a big gain, you wouldn’t get the normal lower rates on the amount of the gain that was due to you taking depreciation. You’d instead pay the lower of your ordinary rate and 25%. If you own shares in a mutual fund that invests in real estate, you might be passed down some of this on a 1099-DIV in box 2b.
“Collectibles gain” works the same way but at 28%. The definition of “collectible” is fairly vague, but includes things like works of art and precious metals. If you own a mutual fund that invests in gold bullion, you might get some of this gain reported to you on a 1099-DIV in box 2d.
The capital gain reported in Box 2c is best left unmentioned.
The total capital gain reported in Box 2a includes all amounts in other sections of Box 2, like how ordinary dividends in Box 1a includes qualified in Box 1b.