Gains from sold investments, known as capital gains, are taxed lower than income. Interest and dividends are taxed as income unless the government considers the dividends “qualified”.
Most people are familiar with income taxes.
Your “marginal tax rate” is what people refer to when they say what “tax bracket” you are in. It is the highest percentage of your income you pay towards income taxes, but not all your income is taxed at this high percentage.
|Marginal Tax Rate||Single||Married Filing Jointly||Head of Household*||Married Filing Separately
|37%||Over $500,000||Over $600,000||Over $500,000||Over $300,000
If you are single, your first $9,525 is taxed at a 10% rate, your next $9,525 to $38,700 is taxed at a 12% rate, and this pattern continues up until those earning $500,000 or more have that amount of their income taxed at a 37% rate.
Your “effective tax rate” is the taxes you pay divided by your gross income and it will be lower than your marginal tax rate.
When you deduct from your taxable income, for example by making contributions to a 401(k), you are reducing your taxable income starting from the last dollar you earned and therefore are avoiding paying the larger marginal tax rate.
Capital Gains Taxes
Fewer people are familiar with how investment gains are taxed.
Any realized gains on investments—that is, money earned from selling a stock, bond, or real estate for more money than you bought it—is also taxed, but not as income. This tax is called “capital gains tax.”
Capital gains are calculated by taking the dollar amount of an investment you sold and subtracting the amount you bought that investment for, which is known as your “cost basis.”
But what if you buy investments routinely such as when you automate your investments monthly? There are a handful of methods to calculate your cost basis, but the most efficient is “specific identification” which allows you to pick which of your purchases of that investment you want to sell.
When selling, you usually want to sell your more expensive purchases to either minimize capital gains (less gain to tax) or maximize tax loss harvesting (a topic for a future post). Once you sell, your brokerage will do the record keeping for you so filing your taxes is easy.
Your capital gains tax rate depends on your earned income. Add your capital gains to your earned income to find your adjusted gross income (AGI) and associated long-term capital gains tax rate.
|Long-Term Capital Gains Rate||Single Taxpayers||Married Filing Jointly||Head of Household||Married Filing Separately
|0%||Up to $38,600||Up to $77,200||Up to $51,700||Up to $38,600
|20%||Over $425,800||Over $479,000||Over $452,400||Over $239,500
Note: An additional 3.8% net investment income tax (NIIT) may apply if you meet one of the following: a) You file a joint tax return or use the qualifying widow(er) status with more than $250,000 in modified adjusted gross income (MAGI), b) You are married filing separately with more than $125,000 in MAGI, or c) You are single or head-of-household with more than $200,000 in MAGI.
Similar to the progressive income tax bracket system, your capital gains will be taxed starting at your capital gains tax rate associated with your last dollar of earned income and will continue at that rate until your capital gains bump you up into a tax bracket associated with a higher capital gains tax rate.
As you can see, long-term capital gains tax rates are lower than income tax rates, but in order for a capital gain to qualify for the preferable long-term capital gains tax rate, you must have owned the investment for at least a year before selling it; otherwise, your gains are considered short-term capital gains and are subject to your higher income tax rate instead.
How are Dividends Taxed?
At its heart, the long-term capital gains tax rate only applies to sold investments that have grown in value since purchase, but it does not apply to interest or dividends generated from those assets.
To incentivize investing in stocks, the government classifies dividends from stocks of U.S. companies with normal company structures (corporations) and some foreign corporations that benefit from U.S. tax treaties as “qualified dividends” that are only subject to the lower long-term capital gains tax rates.
Bonds do not get this treatment. Interest generated from bonds is taxed as income, which is why it is beneficial to keep bonds in tax-advantaged accounts when possible.