Can Capital Gains Push Me Into a Higher Tax Bracket?
No matter who you are, investing is always a smart move. Whether you’re saving for retirement or trying to grow your personal wealth, you need to take advantage of investment opportunities. However, while your money can grow tax-deferred, what happens when you withdraw it? 
In most cases, you will have to pay taxes on capital gains in your taxable (non-retirement) accounts. Fortunately, if you wait until the right moment, you can reduce your tax burden. In some cases, you might be able to save thousands or tens of thousands of dollars.
However, one of the most pressing questions is whether any capital gains will push your income into a higher tax bracket. Because the U.S. tax code is relatively complex, we will break down this question and its potential outcomes for you. Here’s what you need to know.
Understanding Capital Gains: Short vs. Long-Term Investments
First and foremost, you should understand that there is a difference between short and long-term investments. According to the IRS, any gains realized (withdrawn) within a year are considered short-term and taxed at regular income tax rates. For example, if you put money into a six-month certificate of deposit (CD), you would have to pay income taxes on the interest received.
By comparison, long-term investments are those held for more than a year. Even if you wait until the 366th day after investing, your gains will be considered “long-term.” Fortunately, this money is taxed at a much more preferable rate. The logic behind this is to entice investors to keep funds in investments for longer while making that money accessible once it reaches the lower tax bracket.
Just to reiterate - short-term capital gains are taxed at income tax rates, while long-term investments are tax at capital gains rates (which are lower). As we’ll discuss later on, there are various strategies you can utilize to pay as few taxes on your earnings as possible, depending on how they are classified.
Tax Brackets for Short Term Capital Gains
Since these investments are treated as regular income, they are added to any other income you have for the year. As of 2020, the income tax brackets in the U.S. are:
For Single Filers
- Ten Percent - $0 to $9,875 ($9,950 in 2021)
- Twelve Percent - $9,876 to $40,125 ($40,525 in 2021)
- Twenty-Two Percent - $40,126 to $85,525 ($86,375 in 2021)
- Twenty-Four Percent - $85,526 to $163,300 ($164,925 in 2021)
- Thirty-Two Percent - $163,301 to $207,350 ($209,425 in 2021)
- Thirty-Five Percent - $207,351 to $518,400 ($523,600 in 2021)
- Thirty-Seven Percent - Over $518,401 ($523,601 in 2021)
For Married Filing Jointly
- Ten Percent - $0 to $19,750 ($19,950 in 2021)
- Twelve Percent - $19,751 to $80,250 ($81,050 in 2021)
- Twenty-Two Percent - $80,251 to $171,050 ($172,750 in 2021)
- Twenty-Four Percent - $171,051 to $326,600 ($329,850 in 2021)
- Thirty-Two Percent - $326,601 to $414,700 ($418,850 in 2021)
- Thirty-Five Percent - $414,701 to $622,050 ($628,300 in 2021)
- Thirty-Seven Percent - Over $622,051 ($628,301 in 2021)
Tax Brackets for Long-Term Capital Gains
One of the interesting quirks of holding onto your investments for over a year is that you could potentially pay no taxes when withdrawing them. There are only three tax brackets for this group of assets - Zero percent, 15 percent, and 20 percent. Here is a quick breakdown of each threshold.
For Single Filers
- Zero Percent - $0 to $40,000 ($40,400 in 2021)
- Fifteen Percent - $40,001 to $441,450 ($445,850 in 2021)
- Twenty Percent - Over $441,451 ($445,851 in 2021)
Married Filing Jointly
- Zero Percent - $0 to $80,000 ($80,800 in 2021)
- Fifteen Percent - $80,001 to $496,600 ($501,600 in 2021)
- Twenty Percent - Over $496,601 ($501,601 in 2021)
What you’ll notice immediately is that the fifteen percent bracket is massive. Unless you invest hundreds of thousands of dollars at a time, you likely won’t break into the 20 percent tier.
However, the zero-percent bracket is a bit misleading. The $40,000 total doesn’t refer to the gains themselves, but rather your income level. For example, if you made over $40,000 in 2020 (or $40,400 in 2021), you would have to pay taxes on all of your investment earnings. However, if you made less than that, such as $35,000, the $5,000 difference would be tax-free. Here is a quick breakdown to help illustrate how this works:
- Total Taxable Income (Without Capital Gains) = $35,000
- Capital Gains = $15,000
- Total Gains Taxed = $10,000
In this example, $10,000 of your investment earnings would be taxed at 15 percent. The lower your income level, the more of your investments can be realized tax-free. If you had no income source for 2020 but made $40,000 in capital gains, your total tax bill for the year would be nothing.
Income Taxes vs. Capital Gains
Although short-term earnings are added to your adjusted gross income (AGI), long-term gains are not (even though it can look confusing on your 1040...it gets solved in line 16 where you'll complete a worksheet that will help distinguish/take out long-term capital gains when calculating the total tax that needs to be paid). Instead, your AGI is taxed at its own rate (based on the tables shown above), and your long-term investments are taxed separately at capital gains rates. The only reason to combine the two is to determine how much (if any) of your gains would be at the zero-percent rate.
So, when asking whether capital gains will push you into a higher tax bracket, the primary question is whether those earnings were made within a year or longer. Let’s continue to say that you made $35,000 in 2020 and earned an additional $15,000 from investments.
If that $15,000 were from short-term gains, your AGI would be $50,000. According to the 2020 tax brackets, you would have moved from the 12-percent into the 22-percent bracket, which would increase your overall burden significantly.
Before realizing the gains, your tax bill would be $4,002.50 since the U.S. has a tiered system. This means that the first $9,875 is taxed at 10 percent, and the remainder (in this case, $25,125) is taxed at 12 percent.
However, since your investments pushed you into a higher bracket, your total tax bill would be $6,790. In this case, you would be paying $2,790 on earnings of $15,000, or 18.6 percent in taxes.
By comparison, if your gains are long-term, then your tax bill will be far less substantial. As we mentioned, $5,000 of your investment earnings would be tax-free, and the remaining $10,000 would be taxed at 15 percent, or $1,500. In this instance, your total bill would be $5,502.50 when combining the two.
As you can see, there is a significant benefit to holding onto your investments for at least a year. Doing so can reduce your tax burden and ensure that more of that money winds up in your pocket and doesn’t go to the IRS.
Potential Downsides of Claiming Long-Term Gains
Although long-term capital gains will not affect your tax bracket, it can increase your adjusted gross income (AGI) (again, I know this sounds confusing but see comment in the previous section and click the link for more information). Depending on your situation, these earnings can have some adverse side effects, including:
- Roth IRA Contributions - While there are no income restrictions on a traditional IRA, the same is not true for a Roth account. If your gains push you into a high enough AGI, you may not be able to contribute as much to your IRA, if at all.
- Net Investment Income Tax - For individuals with an AGI of $200,000 (or $250,000 for married couples), there is an extra 3.8 percent tax, called the NIIT. So, if your long-term gains push you above this threshold, you could be liable for this tax.
- Standard Deduction - Single filers can claim up to $12,400 for the standard deduction, and married couples can claim $24,800. This deduction counts against the AGI, which can push income into a lower tax bracket. However, if your capital gains match this amount or are higher, you could negate the deduction altogether.
- Earned Income Tax Credit - The EITC is designed to help low-income individuals and couples. If you previously qualified for this, adding capital gains to your AGI could prevent you from claiming the EITC.
Overall, it’s always best to talk with a financial advisor before withdrawing any investment earnings. Because there are multiple strategies and options available, you want to get the most bang for your buck. In the next section, we’ll discuss specific tactics you can utilize to lower your total tax bill when realizing capital gains.
Different Methods to Lower Your Taxes When Realizing Capital Gains
Thankfully, if you are trying to reduce your tax bill while earning investment income, there are some tried-and-true strategies available. Again, talk to a financial advisor before implementing any of these tactics, as they can be somewhat complicated to employ on your own.
Tax Loss Harvesting
Ideally, all of your investments will yield substantial earnings. However, if you lost money with a particular asset, you could use that loss to offset any capital gains. For example, let’s say that you purchased two stocks at $1,000 each. One of the stocks appreciated and is now worth $5,000, while the other reduced to $100.
If you sell both stocks simultaneously, the IRS will allow you to deduct the $900 loss from your $4,000 earnings. In this case, you would only pay taxes on the remaining $3,100. Tax-loss harvesting is not always a good idea, mainly because you can’t purchase the same investment right away. This is called the “wash sale rule,” which prevents investors from rebuying stocks within 30 days of selling.
Typically, the best time to use this strategy is if you are trying to offset a short-term gain with a long-term loss. Since short-term investment taxes are higher, you can reduce your burden substantially. Otherwise, you might be breaking even in the long run.
Income Shifting
Ideally, you will be able to take advantage of the zero-percent tax bracket for your long-term capital gains. One way to do this is to lower your total earnings for the year. Income shifting is one potential strategy as it will reduce your AGI, allowing more of your investment earnings to be claimed tax-free.
Income shifting works by giving money to a spouse or relative. For example, if your spouse doesn’t work (or is in a much lower tax bracket), you can give as much money as you want. In this case, since your spouse is in the 10 percent bracket, you can give up to $9,875 without pushing them over. Assuming that this gift will lower your income well below the $40,000 threshold, you can pay zero taxes on your long-term gains.
Retirement Contributions
If you work for a company that allows you to contribute pre-tax funds to your retirement account (i.e., a 401k), you can take advantage by putting more money away in a particular year. Since the funds are taken from your income pre-tax, it will reduce your AGI.
For example, let’s say that you usually earn $45,000. This year, you want to cash out a long-term investment for $20,000. In this instance, you might want to contribute an extra $10,000 to your retirement account, which will lower your income to $35,000. This way, $5,000 of your capital gains will not be taxed at all.
Alternatively, you can contribute to a traditional IRA and lower your AGI that way. Since those contributions are tax-deferred, they count against your regular income.
Contact Us Today
Lowering your tax bill doesn’t have to be complicated or time-consuming. At NextGen Wealth, we can work with you to ensure that more of your earnings stay in your pocket. We can also assist you with other long-term financial planning, such as retirement or buying a home. Call us today to get started.
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