For a long time, capital gains taxes were pretty straightforward. If you purchased property for investment and held it for more than a year, the government taxed any gain at a lower rate than they would ordinary income. In recent years, however, changes to the tax code have introduced three capital gains tax brackets (0%, 15% and 20%), similar to ordinary tax brackets. In addition, the Medicare surtax can add 3.8% onto the 15% and 20% capital gains brackets, resulting in a maximum capital gains rate of 23.8%. This means capital gains will usually end up being taxed across multiple brackets, just like ordinary income. 

Unfortunately, the complexity doesn’t end with the brackets. Most folks have both ordinary income from sources like wages or social security and capital gains from investments. Once you have more than one type of income, it can affect where you end up in the capital gains brackets. This has to do with the ordering rules for income. The rules require that ordinary income less deductions come first when calculating taxable income. Taxable income is then run through the ordinary income tax brackets. Next, to determine which capital gains bracket to apply, long-term capital gains are added to the ordinary taxable income. This doesn’t mean that ordinary income is being taxed twice. The ordering rules just add capital gains on top of ordinary income for the purposes of calculating the capital gains rate. Here’s a quick example to clarify the process:

John and Jane file taxes under the status “married filing jointly” and have $50,000 of ordinary income and $75,000 of capital gains. They opt for the standard deduction, which in 2023 is $27,700. First, the $50,000 of ordinary income less the standard deduction is applied to the ordinary income brackets. That’s $22,300 ordinary income taxed over the 10% and 12% ordinary income tax brackets. The $75,000 of capital gains is then added to the $23,300, which results in the $75,000 of capital gains being taxed across the 0% and 15% capital gains brackets. If John and Jane had no ordinary income after deductions in 2023, all of the capital gain would have been taxed at 0%.

From this simple example you can see how ordinary income can potentially crowd out the 0% and 15% capital gains brackets. Every additional dollar of John and Jane’s ordinary income is being taxed at 27% instead of 12% because it pushes more capital gains income out of the 0% bracket. 

As you can see, the application of these rules can affect decisions around which type of, and how much, income to take in a given year. If you have little to no ordinary income and you have the choice of taking an IRA distribution or capital gains, it may make sense to take the capital gains for the best tax result. When analyzing Roth conversions, the interplay between ordinary incomes and capital gains brackets can affect your decision. 

In addition, the Medicare surtax mentioned above is calculated separately when your modified adjusted gross income exceeds a certain threshold. The surtax is not only applied to capital gains but also interest, dividends, rents, and other passive income. The bottom line is, failing to consider the interplay between capital gains and other sources of income can lead to you paying more in taxes. 

Resources:

www.kitces.com/blog/long-term-capital-gains-bump-zone-higher-marginal-tax-rate-phase-in-0-rate/

IRS Tax Topic No. 409 Capital Gains and Losses

IRS Tax Topic No. 559 Net Investment Income Tax