Capital Gains and Ordinary Income Tax
The long-term capital gains and dividends tax rate is lower than the ordinary income tax rate, but can realizing capital gains cause your wages or IRA withdrawals to be taxed at a higher rate? That's an important question for whenever you are planning to take capital gains, whether you are coordinating retirement withdrawals or straddling between tax brackets.
The bad news is that capital gains will drive up your adjusted gross income (AGI). As your AGI increases, you begin to get phased out of personal exemptions, itemized deductions, certain tax credits, and make you ineligible for Roth IRA or deductible IRA contributions.
The good news, however, is when you take capital gains, tax rates apply FIRST to your ordinary income. So long-term capital gains and dividends which are taxed at the lower rates WILL NOT push your ordinary income into a higher tax bracket.
Long-term Capital Gains at 0%
The long-term capital gains tax is 0% if realized in the 15% bracket. But what happens when some of those gains are in the 15% bracket and cross over into the 25% bracket? Fortunately, a little spillover into the 25% bracket will not make the entire gain taxable at the higher marginal rate.
Let's look at an example. If your ordinary income is $5,000 below the 25% tax bracket and you have a $10,000 long-term capital gain, you pay 0% tax on first $5,000 of the gain and 15% tax on second $5,000. The ordinary income remains in the 15% bracket.
Long-term Capital Gains and Roth Conversions in Retirement
Let's look at another, more extreme example. Let's say you just retired and no longer have earned income. Therefore, you want to convert IRA dollars to Roth to fill up lower tax brackets. But in order to do so, you'll need to realize capital gains to meet your living expenses. Let's say you require $200,000 to meet living expenses and must realize $150,000 of long-term capital gains.
If tax rates didn't apply to ordinary income first, the Roth conversion amount would stack on top of the $150,000 long-term capital gain. However, since tax rates DO apply to ordinary income first, you can also convert up to $100,000 of your IRA to Roth in the 10% and 15% brackets (after exemptions/itemized deductions)!
Knowing the correct order of taxation for different types of income can open up a wide range of tax planning opportunities.