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The Short Answer

Understanding Capital Gains Tax Brackets

For those whose ordinary income falls below the 25% bracket, some or all gains might be tax-free.

Question: My spouse and I own mutual funds that spin off about $10,000 in capital gains each year. Our income puts us in the 15% tax bracket for capital gains by just a few hundred dollars, but do we have to pay 15% tax on the full $10,000?

Answer: Many taxpayers misunderstand how the tiered structure of our income tax system works, and this applies not just to the brackets used to calculate taxes on ordinary income, such as salaries and commissions from working, but also to those used to calculated taxes on investment-related income, such as capital gains and dividends. In particular, some assume that the tax bracket they fall into determines the rate they pay on all of their income, but that's not correct.

To clarify, in most cases, the tax rate you pay on your last penny of income is not the same as the rate you pay on the first. So someone in the 25% tax bracket is not paying a 25% tax on all of his or her income. Rather, only income that falls within the 25% bracket is subject to taxation at that rate, while the portion of the person's income that falls within lower brackets is taxed at those lower rates.

To illustrate, consider a married couple filing jointly who had taxable income of $80,000 in 2012. That puts them within the 25% tax bracket, but not all of their income is taxed at that rate--if it were they would owe $20,000 in taxes. Rather, the first $17,400 of their income is taxed at the 10% rate (based on brackets for the 2012 tax year), additional income up to $70,700 is taxed at 15%, and only the amount above that--in this case $9,300--is taxed at 25%. This works out to them owing about $12,060 in taxes for an effective tax rate of 15.1% on all their taxable income.

Where Capital Gains Fit In
Under tax rules made permanent by the fiscal cliff agreement passed earlier this year, taxpayers in the 10% and 15% income tax brackets don't have to pay any taxes at all on long-term capital gains (which are those from the sale of assets held at least one year), while those in the 25%, 28%, 33%, and 35% brackets pay a 15% rate, and those in the 39.6% bracket pay a 20% rate staring in 2013. (Short-term capital gains are taxed as ordinary income, as are nonqualified dividends; qualified dividends are taxed at the same rate as long-term capital gains and use the same brackets.) So the cutoff for having to pay any capital gains begins at the 25% income bracket, which for 2013 starts at $72,501 for married couples filing jointly and at $36,251 for singles.

What some taxpayers fail to realize is that long-term capital gains (and qualified dividends) are added to ordinary income for the purpose of determining which capital gains tax rate is paid. So if a married couple makes $50,000 in ordinary income but has $30,000 in long-term capital gains, this combined $80,000 in taxable income makes a portion of those capital gains subject to taxation (even though the ordinary income alone isn't enough to put them into the 15% bracket for capital gains). The good news is that only the portion of capital gains that falls within the 15% capital gains tax threshold is subject to tax.

So for our couple mentioned above, only $7,499 of their $30,000 in capital gains is subject to tax (with a total capital gains tax of $1,125, or $7,499 x 0.15). That's because the first $22,501 in capital gains, combined with their ordinary income of $50,000, falls below the 15% capital gains threshold (remember that the starting point for having to pay taxes on long-term capital gains in their case is $72,501). In essence, they are paying a 0% rate on the first $22,501 in capital gains and 15% on the rest.

If by now your head is swimming with tax rates and dollar figures, don't worry. That's a perfectly normal reaction, and it's also why the accounting profession and tax software were invented.

Lowering Your Capital Gains Tax Exposure
For taxpayers whose combined ordinary income, long-term capital gains, and qualified dividends put them well within the bracket breakpoints (again, the 15% rate on long-term capital gains and qualified dividends starts at $36,251 for singles and $72,501 for joint filers, while the 20% rate starts at $400,001 for singles and $450,001 for joint filers), reducing income enough to avoid having to pay any taxes on these types of investment-related income, or reducing the rate they have to pay, may not be realistic. 

But for those just slightly above these limits, there are strategies that may help them drop to a lower bracket. An obvious one is simply to lower your capital gains by selling fewer appreciated assets, by selling those that have depreciated, or by avoiding mutual funds that do a lot of trading and thus generate capital gains that are passed on to shareholders. Another is to lower your taxable income by boosting contributions to tax-deductible retirement accounts, such as a traditional IRA or 401(k). A third idea is to boost your charitable giving to increase your deductions, thereby lowering your taxable income.

Trying to reduce the taxes you pay on investment-related income is certainly a worthwhile goal. To maximize your savings, it's essential that you understand how the tax brackets on this type of income work, seeking out help from a tax professional if necessary.

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