Kitces: Beware the capital gains bump zone
Long-term capital gains have received preferential tax rates for most of their history. Only in recent years have they 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 20% for the highest earners — still a relative deal compared to a 37% top tax rate on ordinary income.
However, the significance of this phenomenon is greater than the sum of its percentages.
The interrelationship between ordinary income and long-term capital gains creates a form of capital gains bump, where the marginal tax rate on ordinary income can end up being substantially higher than the household’s tax bracket alone. Additional income is both subject to ordinary tax brackets and also drives up the taxation of long-term capital gains or qualified dividends in the process.
Clearly, it’s a lot for an advisor or tax planner to manage when working with clients. The important factor to bear in mind is that evaluating marginal tax rates is a function not just of the ordinary income or long-term capital gains rates themselves, but also how the two interrelate.
As a means to support and incentivize economic investment, the modern tax code for most of its history has provided a tax preference for long-term capital gains. In fact, most developed nations have preferential rates for capital gains over ordinary income. And since 2003, qualified dividends — i.e., for those investing in companies that choose to pay out their profits as dividends instead of reinvesting them into the company — have also been eligible for the same preferential rates.
However, preferential capital gains tax rates are not just taxed at a single, more favorable rate. Instead, similar to the regular tax system, capital gains are actually subject to three different brackets — effectively a series of graduated tax rates similar to the ordinary income tax brackets.
Though it’s worth noting that since the tax law changes passed in December 2017 started taking effect, long-term capital gains rates have had their own tax bracket thresholds that are separate from the ordinary income tax brackets.
Additionally, long-term capital gains and qualified dividends are also subject to the 3.8% Medicare surtax on net investment income, which has its own thresholds of $200,000 of AGI for individuals and $250,000 for married couples, not adjusted for inflation.
This means that in practice there aren’t really just three long-term capital gains tax brackets, but four — at 0%, 15%, 18.8% (i.e., the 15% bracket plus the 3.8% Medicare surtax) and 23.8% (i.e., the top 20% long-term capital gains tax rate with the 3.8% Medicare surtax stacked on top).
Notably though, long-term capital gains rates are still graduated tax rates, akin to the ordinary income tax system. This means that just landing in the 0% long-term gains tax bracket doesn’t allow for unlimited long-term capital gains at 0%. While the tax rate may be 0%, capital gains are still income, and would eventually push the individual up and out of the 0% bracket.
Example 1. Phoebe is considering whether to take a $100,000 distribution from her IRA or liquidate $100,000 of zero-basis stock. For the purposes of the example, assume any other income Phoebe has was already offset by her available deductions.
If Phoebe takes the $100,000 from her IRA, the income will span across the 10%, 12% and 22% tax brackets, resulting in a tax bill of (10% x $9,700) + (12% x $29,775) 12% + $60,525 x 22% = $19,069, or a blended effective tax rate — combining the income across each of the three tax brackets — of about 19.1%
By contrast, if Phoebe took a $100,000 long-term capital gain this year and is in the bottom tax bracket, then she is eligible for the 0% long-term capital gains rate. However, the 0% rate only extends up to $39,375 of income for a single taxpayer, beyond which the 15% capital gains bracket kicks in.
As a result, Phoebe will owe $9,094 in long-term capital gains taxes, which includes 0% on the first $39,375 of long-term capital gains, and 15% on the last $60,625 of long-term capital gains, for a blended effective tax rate of 9.1%.
The end result is that just like the ordinary income tax system, long-term capital gains will typically be taxed at a blend of multiple tax brackets. Though at the margin, planning for the next dollar of income or deductions will still be based on the current marginal tax bracket for ordinary income or long-term capital gains.
Unfortunately, the process of managing long-term capital gains and ordinary income tax brackets is messier when there is a combination of each — which in practice is common, as most taxpayers who have capital gains also have at least some ordinary income as well. Once there is some of each type of income, it’s necessary to figure out the order in which to stack them.
In practice the rules for stacking ordinary income and long-term capital gains are relatively straightforward: ordinary income first, long-term capital gains and qualified dividends second. Any available deductions are applied against ordinary income first.
Example 2. Joseph and Rachel are married and have $60,000 of ordinary income, on top of which they are taking a $60,000 capital gain as well. In 2019 they will be eligible for a $24,400 standard deduction.
Under the ordering rules for ordinary income and capital gains, the $24,400 standard deduction will be applied first against the $60,000 of ordinary income, on top of which the $60,000 long-term capital gain will be stacked. This results in $35,600 of ordinary income that falls within a combination of the 10% and 12% tax brackets, for a total ordinary income tax liability of $3,884, while the remaining $60,000 long-term capital falls across the 0% and 15% long-term capital gains tax brackets — with the first $43,150 falling in the 0% bracket up to the threshold, and the remaining $16,850 taxed at 15%, for a total capital gains tax liability of $2,528.
Historically, the fact that ordinary income came first, and long-term capital gains were stacked on top, always produced the best result for the taxpayer. That’s because until the advent of the 0% capital gains tax bracket, it was better to get the lowest ordinary income tax brackets first and then stack a flat 15% capital gains tax on top, than have long-term capital gains come first and then stack ordinary income at ever-increasing tax brackets on top.
But given the current tax environment, the fact that ordinary income is stacked first has a different effect: It crowds out the available 0% long-term capital gains tax bracket. To the extent that ordinary income fills the bottom two tax brackets first, there literally isn’t as much room left to claim 0% long-term capital gains tax rates before the gains themselves get pushed up into the 15% tax bracket.
BEWARE THE BUMP
From a planning perspective, there’s a reason why the ordering of ordinary income and long-term capital gains matters so much. Because long-term capital gains are always stacked atop ordinary income after deductions, a growing level of ordinary income can end out not only increasing that tax bracket, but by crowding out the bottom brackets it can also bump up the long-term capital gains rate that is stacked on top as well.
Example 3. Continuing the prior example, assume that Joseph and Rachel decide to take out another $10,000 IRA distribution, on top of their $60,000 of existing ordinary income and $60,000 of long-term capital gains.
Thanks to the ordering rules, the additional $10,000 of income will still be taxed at the favorable 12% ordinary income bracket, bringing their total ordinary income after the standard deduction to $45,600, for a total tax liability of $5,084.
However, because the 0% long-term capital gains bracket ends at $78,750, only $33,150 of room remains in the 0% capital gains tax bracket, which means $26,850 gets taxed at the 15% long-term capital gains rate, for a total capital gains tax liability of $4,028. The end result is a total tax bill of $5,084 + $4,028 = $9,112, compared to a previous tax liability of just $6,412.
This means that while the $10,000 distribution was in the 12% ordinary income tax bracket, the couple’s tax liability increased by $2,700 — including $1,200 of additional taxes on the IRA distribution itself, plus $1,500 of additional taxes on $10,000 of long-term capital gains that were pushed up from the 0% long-term capital gains rate to the 15% bracket instead.
As the above example highlights, the manner in which long-term capital gains stack on top of ordinary income can create a bump zone of higher marginal tax rates, where additional non-capital-gains income still increases the taxes on capital gains by driving them up into higher brackets. In this case, additional ordinary income in the 12% tax bracket was taxed at 27% because the income also drove up the capital gains tax liability by pushing more gains out of the 0% bracket.
This bump zone will result any time capital gains span one of the bracket thresholds — from 0% to 15%, 15% to 18.8% or 18.8% to 23.8% — where non–capital gains income can cause additional capital gains taxes. This is in spite of the ironic fact that just having additional long-term capital gains means they’re not taxed so severely, because additional capital gains go on top of the existing gains rather than bumping them up.
Example 4. Continuing the prior example, assume instead that Joseph and Rachel decide not to take a $10,000 IRA distribution — given the 27% marginal tax rate that will apply — and instead simply liquidate another $10,000 of their zero-basis stock instead, producing an extra $10,000 of long-term capital gains for a total of $70,000 in long-term capital gains.
The couple’s ordinary income tax liability will remain at its original $3,884 — a combination of $19,400 in the 10% bracket and the remaining $16,200 in the 12% bracket — while their long-term capital gains will continue to benefit from the 0% bracket for the first $43,150, and the remaining $26,850 taxed at 15%, for a total liability of $4,028.
The end result is that the couple’s total tax bill is now $3,884 + $4,028 = $7,912, an increase of only $1,500, or a marginal tax rate of 15% on the $10,000 of additional income.
Notably, the couple in this example netted out with a lower tax impact by claiming long-term capital gains at the 15% long-term capital gains tax bracket, than an IRA distribution at only the 12% ordinary income bracket. That’s because the capital gains bump zone caused their ordinary income tax rate to actually jump up to 27%.
A similar phenomenon can occur any time additional ordinary income causes a portion of long-term capital gains to be pushed across a threshold to the next higher capital gains tax rate. For married couples approaching $250,000 of modified AGI, the 24% ordinary income tax bracket becomes a 27.8% bracket — as the 3.8% Medicare surtax begins to get stacked atop the long-term capital gains that are pushed over the threshold — and the 35% tax bracket becomes a 40% marginal tax rate as the couple moves up from the 18.8% to 23.8% capital gains rates.
The graphic below shows the bump zones that would stack on top of ordinary income tax brackets for households with $20,000 of long-term capital gains and that incrementally added more ordinary income. As expected, three different bump zones emerge as long-term capital gains cross the thresholds from the 0% to 15% brackets, from 15% to 18.8% and lastly, from 18.8% to 23.8%. Note that the middle bump zone threshold is technically based on AGI and not taxable income, and thus may occur at a slightly higher or lower level of taxable income in practice.
THE RETIREMENT WRINKLE
In many cases, the capital gains bump zone simply is what it is — a higher marginal tax rate that occurs on a portion of ordinary income because it drives up the taxation of capital gains stacked on top. To illustrate, those who are still working and earning wages, and who also have some capital gains income, may net out having their wages or bonuses trigger the capital gains bump zone, but it’s generally not feasible to ask the employer to wait and not pay wages just to avoid it.
However, retirement income — and especially taxable income — is far more malleable. From making decisions about the sequencing of which retirement accounts to draw down first to engaging in partial Roth conversions to fill up low tax brackets, there’s often a great deal of proactive tax planning available when some level of taxable income will occur in the process of generating the necessary retirement cash flows. But there’s a lot of flexibility in how exactly those cash flows are generated.
In this context, the capital gains bump zone should simply be viewed as a factor that increases the marginal tax rate, and may make the relative value of drawing on a retirement account — either via distribution or Roth conversion — more or less appealing. For instance, a single retiree who wanted to fill the 12% tax bracket with a partial Roth conversion but faces the 27% bump zone may not want to convert after all. Meanwhile, a more affluent married couple in the 24% tax bracket that is increasing to 27.8% with the Medicare surtax bump zone may still decide to take distributions from the IRA now, because it’s better than deferring too much and ending in the 32%+ tax bracket when RMDs begin.
The ultimate goal is still to minimize taxes on retirement accounts over life by accelerating income when tax rates may be lower — thereby filling the more favorable tax bracket buckets today — and deferring income when tax rates are higher, and/or anticipated to be equal or lower in the future. The capital gains bump zone simply increases that marginal tax rate when doing the tax equilibrium comparison between current and future tax rates, which may or may not dull the appeal of creating the taxable income in the first place.
Nonetheless, it may surprise many retirees to discover that even with just $50,000 to $100,000 of taxable income for a married couple or $30,000 to $70,000 for singles — which normally would land them in the 12% tax bracket — the marginal tax rate may actually be 27% if there is a mixture of ordinary income and capital gains.
And the effect can be even more severe for those who are also phasing in the taxability of Social Security benefits, which can similarly create a tax torpedo that spikes the marginal tax rate on the 12% tax bracket to 22.2% instead — and conceivably can cause a married couple’s tax bracket to rise as high as 40.7% for those in the 22% ordinary tax bracket who are still phasing in the taxation of Social Security benefits. And all of these can be stacked on top of the capital gains bump zone as well.
Example 5. Chandler and Monica are retired, and thanks to the fact that both had well-paying careers, are each eligible for nearly $2,400 per month in Social Security benefits. Because Chandler is four years older, his Social Security benefits have been further increased to $3,168 per month with delayed retirement credits.
In addition to their combined $5,568 monthly ($66,816 annually) Social Security benefits, the couple is also drawing $28,000 per year from Chandler’s IRA due to RMDs, and liquidated another $32,000 in long-term capital gains this year.
For the purposes of Social Security taxability, the couple’s provisional income is $28,000 + $32,000 + $66,816 / 2 = $93,408, which is $49,408 in excess of the $44,000 threshold for Social Security taxation, resulting in $49,408 x 85% = $41,997 of their Social Security benefits being taxable, plus another $6,000 of taxable Social Security benefits — i.e., 50% of the amount between the $32,000 and $44,000 Social Security taxability thresholds — for a total of $47,997 of taxable Social Security benefits.
Thus, the couple’s total ordinary income is $47,997 + $28,000 = $75,997, reduced to $51,597 after the $24,400 standard deduction, placing them in the 12% ordinary income tax bracket. On top of this the couple will have $32,000 of long-term capital gains, which spans the $78,750 threshold for the 0%-to-15% long-term capital gains rate for a married couple. Consequently, for any income that is created Chandler and Monica will both face the phase-in of Social Security taxation as well as the capital gains bump zone.
If the couple were to withdraw another $10,000 from their IRA while they are current in both the Social Security phase-in zone and the capital gains bump zone, not only would their ordinary income increase by $10,000 but the taxable portion of their Social Security would also increase by $8,500 — and $10,000 of their long-term capital gains would be pushed up into the 15% zone.
The end result is that under the original scenario, the couple’s tax liability was $5,804 on their ordinary income of $51,597, plus $727 of capital gains taxes on the $4,847 of capital gains that was over the line into the 15% tax bracket, for a total tax liability of $6,531. With the additional $10,000 of income though, the couple’s ordinary income rises to $70,097, producing an ordinary income tax liability of $8,024 in addition to increasing their capital gains tax liability to $3,502 — as now most of their long-term capital gain is above the 0% threshold — for a total tax liability of $11,526.
This means their $10,000 of additional income generated $11,526 - $6,531 = $4,995 of additional taxes, or a whopping 49.95% marginal tax rate, due to the combination of Social Security benefits phase-in plus the capital gains bump zone, and the interaction effect between the two. That tax rate is ultimately the combination of 12% on ordinary income + 15% on long-term capital gains = 27% x 1.85 (the Social Security inclusion multiplier) = 49.95%.
Another planning consideration that arises from the capital gains bump zone is the coordination of capital gains harvesting to take advantage of the 0% tax rate, and doing partial Roth conversions to fill the lower ordinary income tax brackets and avoid potentially higher tax brackets in the future. That’s because, as noted earlier, the decision to do a partial Roth conversion to fill up the lower ordinary income brackets also crowds out any room to do 0% capital gains harvesting as well.
In prioritizing the two, the ultimate question is to determine which produces better long-term tax savings — i.e., the tax bracket that would apply now, versus the one that might otherwise apply in the future.
For those who have negative taxable income — i.e., deductions exceed income in the first place — partial Roth conversions will effectively have a marginal tax rate of 0% at least at the Federal level. And arguably it’s hard to ever beat 0% on a pre-tax retirement account. This means absorbing any negative taxable income with a partial Roth conversion comes first.
From there, it’s difficult to beat 0% on long-term capital gains, at least unless the household anticipates either holding the stock until death — i.e., to get 0% capital gains with the step-up in basis at death — or donating it directly to a charity or via a donor-advised fund to avoid the capital gains tax liability. Thus, for anyone who does not anticipate dying with or donating their highly appreciated portfolio investments, harvesting 0% capital gains to avoid 15%+ rates in the future will generally be superior to ordinary income harvesting at 10% or 12% when the household would likely just rise to the 22% tax bracket in the future. This is especially true since partial Roth conversions — presuming there are capital gains present — can trigger the capital gains bump zone, making those conversions especially unappealing.
Though once the 0% long-term capital gains bracket is crowded out — e.g., for those households that already have too much in Social Security benefits, pensions, passive income, RMDs or other income sources, and are no longer exposed to the AMT bump zone — it again becomes more appealing to conduct partial Roth conversions, as harvesting retirement accounts at the 22% or even 24% tax rates to avoid the 32%+ brackets will generally be more beneficial than just avoiding the 3.8% capital gains increase that occurs as the capital gains rate rises in the future.
And in the most extreme cases, it may even be smart to harvest partial Roth conversions at 32% or 35% tax brackets just to avoid the very top (37%) tax bracket in the future, while again being mindful of the upper capital gains bump zone that kicks in at $434,550 of income for individuals and $488,850 for married couples.
The bottom line is simply to understand that while long-term capital gains get stacked in what is otherwise a favorable manner on top of ordinary income — with deductions applied first against the ordinary income base — any increase in ordinary income can be subject to a form of double taxation by both being taxed directly and causing the capital gains stacked on top to fall into higher tax brackets.
This will grow even more common in the coming years, given the tax law changes misaligned the long-term capital gains and ordinary income tax brackets, creating many scenarios where ordinary income in one bracket may still cause a bump zone in the capital gains rates.
So when evaluating marginal tax rates — the anchor of any long-term tax planning — and trying to find the optimal tax equilibrium to fill up low current tax brackets to avoid pushing into higher ones in the future, it’s crucial to consider not just the brackets that apply to ordinary income, but the indirect effects of triggering additional capital gains taxes on top.