While long-term capital gains have had preferential tax rates for most of their history (and receive similar treatment in most developed countries around the world), it’s only in recent years that long-term capital gains have been subject to not just one, but a series of tiered preferential rates, from a 0% rate for those in the lowest tax brackets, to 15% for those in the middle, and 20% for the highest earners (albeit still a “deal” relative to a 37% top tax rate on ordinary income). Plus a 3.8% Medicare surtax that stacks on top of a portion of the 15%, and all of the 20%, long-term capital gains rates.
The significance of this phenomenon is that, similar to ordinary income tax rates, generating “too much” in capital gains can drive the household up into higher capital gains tax rates. And because capital gains income stacks on top of ordinary income, even just increasing ordinary income can effectively crowd out room for preferential long-term capital gains rates.
In fact, the interrelationship between ordinary income and long-term capital gains creates a form of “capital gains bump zone” – where the marginal tax rate on ordinary income can end out being substantially higher than the household’s tax bracket alone, because additional income is both subject to ordinary tax brackets and drives up the taxation of long-term capital gains (or qualified dividends) in the process.
For instance, individuals with as little as “just” $30,000 of income (after deductions) and some capital gains on top who would normally be in the 12% tax bracket may face marginal tax rates as high as 27% due to the capital gains bump zone. And upper-income households eligible for the 35% tax bracket may face a marginal rate of 40% as the top capital gains tax bracket phases in. The effect can be even worse for retirees who also claim Social Security benefits, where the combination of phasing in Social Security benefits, and driving up long-term capital gains to be subject to the 15% rates, can trigger a marginal tax rate of nearly 50%(!) for a household otherwise in the 12% ordinary income tax bracket!
As a result, it’s crucial to consider the coordination of long-term capital gains with ordinary income, and the phase-in of Social Security taxation. For those with negative taxable income, it is generally still appealing to do partial Roth conversions at a marginal tax rate of 0%. But for others in the bottom tax brackets, it may be preferable to harvest 0% long-term capital gains instead (and not do partial Roth conversions that will undo the 0% rate on those capital gains!). While higher-income individuals may prefer to once again do partial Roth conversions in the 22% and 24% brackets, or even the 32% bracket… while avoiding the additional capital gains bump zone that occurs in the 35% bracket.
The bottom line, though, is simply to understand that with 7 ordinary income tax brackets, plus 4 long-term capital gains brackets (with the 3.8% Medicare surtax), tax planning and evaluating marginal tax rates is a function of not just the ordinary income or long-term capital gains rates themselves, but also the interrelationship of the two and the indirect but substantial tax impact of adding more ordinary income when there are already substantial long-term capital gains stacked on top!