Does Standard Deduction Apply to Capital Gains?
There is a separate (and some would say mystical) system of taxation for long-term capital gains and qualified dividends. Let’s talk about Long-Term Capital Gains Tax and how the standard deduction applies to capital gains.
Ordinary income has its own progressive tax brackets, but these tax brackets interact with Long-Term Capital Gains Tax and cause all sorts of confusion.
Let’s learn about how long-term capital gains tax stacks on top of ordinary income, and how the standard deduction applies to capital gains.
Long-Term Capital Gains stack on TOP of ordinary income.
Let’s explain how that works and look at updates for Long-Term Capital Gains rates.
As per usual, Kitces has the best graphics on the internet demonstrating difficult tax concepts.
In figure 1, the numbers are a bit off due to yearly changes but let’s look at what happens conceptually.
Green is ordinary income, yellow capital gains.
The first ~18k of ordinary income is subject to the 10% tax bracket in this example. The next ~11.5K the 15% tax bracket. Stacked on top of that, again in yellow, are Long-Term Capital Gains.
Did you know there is a zero percent Long-Term Capital Tax bracket? That’s righ, up to the limit of the zero percent LTCG bracket there are zero taxes paid! Above that, you hit the 15% Capital Gains tax bracket.
Let’s spell that out again. Up until you reach the 15% Long-Term Capital Gains tax bracket, you pay zero on the capital gains that stack on top of your ordinary income. Above that amount, you are now in the 15% LTCG tax bracket and pay 15%.
Note the important concept of your total taxable income in Blue. This includes Both ordinary income and capital gains. If you want to actually look at a 1040, this is line 7a.
Before this, you get to deduct your pre-tax deductions such as your 401k. After this, you get below the line deductions and the standard deduction. Most people hate taxes so I’m just going to hand-wave and gloss over this part.
How does the standard deduction affect the Long-Term Capital Gains taxes? I’m glad you asked.
How the Standard Deductions applies to Long-Term Capital Gains Tax
Below we can see how the standard deduction affects long-term capital gains tax.
In green, again, is ordinary income. Then you take the standard deduction in Red. This decreases the starting point for our next step, which will be adding the Long-Term Capital Gains.
But before we do that, we have ordinary taxes due. You pay taxes on ordinary income depending on the amount you have exposed to the ordinary income tax brackets. That should make sense to you.
There is the effective tax rate, that is the amount of total tax you pay divided by your income.
Next, you have the marginal rate. That is the amount you pay on the next dollar of income you earn. Those tax brackets apply to ordinary income.
ABOVE your ordinary income, you stack on Capital Gains.
If you don’t have any ordinary income, the the standard deduction applies to capital gains.
In Dark Blue, some of the Long-Term Capital Gains are exposed to the zero percent capital gains tax bracket. Above that, the rest of the capital gains are exposed to the 15% capital gains bracket.
This Dark Magic actually happens on line 12a on your 1040. Let’s look at that now.
The Dark Magic of Capital Gains Tax
Look at how to calculate Line 12a. I know, control your excitement. I looked for an update of this form on line but honestly it is hard to find. No one calculates this by hand and the computer just does it for you. So much so, that I’ve found CPAs often can’t exactly explain how long term capital gains tax sit on the ordinary tax brackets. Seriously, ask one the next time you see one at a party. Do CPAs go to parties?
Note that line 8 of this form subtracts out the money exposed to the zero percent bracket, so you are left with the taxable portion of Long-Term Capital Gains at that point.
Line 15 then removes the part above the 15% tax bracket so you can pay 20% on that amount. Easy! Just two steps to get the three tax brackets; zero, 15 and 20%.
But wait, don’t forget about NIIT!
Don’t Forget about NIIT
NIIT is annoying as it sounds. The Net Investment Income Tax (NIIT) is a 3.8% Medicare tax that phases in for MAGIs above $200k/$250k filing as individual/jointly respectively.
Those who enjoy paying NIIT will get to file form 8960. Look at line 17 as that’s where the damage is done. You take the calculated amount above the phase out and multiple it by 3.8%. Cha-Ching! That’s what you owe in NIIT.
Much beyond that it gets too confusing to contemplate. No one reading this ever wanted to be a CPA…
So, NIIT changes the number of tax brackets depending on if you are above or below the threshold.
How Many Long-Term Capital Gains Tax Brackets Are There?
Most people think they are three capital gains tax brackets: zero, 15, and 20%.
They are wrong! There are actually four Long-Term Capital Gains brackets thanks to NIIT!
Don’t forget the numbers change every year. The update is below.
Regardless, the important idea is visualizing the 4 separate Long-Term Capital Gains tax brackets. Here you can see them in all their glory!
There is actually no 20% Long-Term Capital Gain tax bracket. How about that? Instead, anytime you are above the 20% LTCG bracket, you are also above the NIIT threshold, so you get to pay both.
The Long-Term Capital Gains Tax brackets are zero, 15, 18.8, and 23.8%. Love it.
What are the implications of the LTCG brackets? Let’s talk briefly about capital gain harvesting.
Capital Gain Harvesting
During your Tax Planning Window, you have a golden opportunity to control your income. There are many wonderful things you can do, such as partial Roth Conversions, but let’s focus on Capital Gain harvesting.
By the way. For DIY, this might be an important time to use some professional Financial Planning Software. I’m not saying you have to hire someone to do it, but find a way to get it done. You can actually get free plans if you look around. Retirement income planning is complicated with many different considerations. Taxation of social security, IRMAA, Widow/Widower Tax Penalties, etc. There are actually multiple competing goals that must need considered.
Assuming you are a couple, you need to have at least enough ordinary income to offset the standard deduction. If you waste the standard deduction, shame on you! You can either earn that income (W2 or 1099), or you can distribute that amount form your pre-tax accounts. Also, don’t waste your standard deduction on LTCGs! Deduct your ordinary income!
Beyond that, you could rescue your pre-tax money at the 10 and 12% tax brackets, or you can sell off your winners in your brokerage account at the zero percent LTCG rate.
So, for example, after taking about ~24k of ordinary income, a couple could have about ~78k of capital gains and pay zero in taxes! Pretty exciting stuff.
Don’t forget about Qualified Dividends
Don’t forget that Qualified Dividends also get special tax treatment. What is a qualified dividend? Well, a dividend that isn’t ordinary is qualified. Ordinary dividends suck. They get exposed to ordinary tax rates.
So, what is an ordinary dividend? Look back at the form 1040 above and note there are two lines 3a and 3b for qualified and ordinary dividends, respectively. These are both “regular” dividends for tax purposes. Ordinary dividends don’t meet criteria to be called a qualified. This can be due to investment type (REITs, MLPs, money market accounts etc) or duration. There is a 60-day holding period you need have owned the stock before dividends are paid in order to get qualified treatment.
In general, if you are a buy-and-hold investor, don’t worry about ordinary vs. qualified. You will get a 1099-DIV that tells you what number to put in what box.
Long-Term Capital Gains Tax Rate Update
There are new Long-Term Capital Gains Tax rates where the brackets have been adjusted upwards for inflation.
As you can see above, the zero percent tax bracket now extends up to $80k for folks married filing jointly. Due to NIIT, the 15% long-term capital gains rate remains at $250k, and $200k for those filing single. You then hit the 18.8% bracket until you get into the 23.8% bracket at the specified incomes (reported as 20% above).
Video: Does Standard Deduction Apply to Capital Gains?
Summary Long-Term Capital Gains Tax
So, here is your chance to show off. What did you learn?
As I mentioned in the beginning, most people are confused about how they pay taxes on their long-term capital gains.
Remember that long-term capital gains stack on top of ordinary income. So, take your income, minus the standard deduction, and add your long-term capital gains and qualified dividends. This is the amount of money on which you pay Long-Term Capital Gains Taxes. Remember, the standard deduction reduces capital gains if you have no ordinary income.
Also remember, if there is room in the zero percent tax bracket, you pay zero in taxes on the amount that fits in that bracket. Above that, you pay 15% until you get to the 18.8% bracket. Above a certain amount, you pay 23.8% taxes on the remaining Long-Term Capital Gains.
See, easy! Bet you won’t remember how to do that a week from now…