Capital Gains and Taxable Income

[bmjohnson35]

I am working on my 2022 income/tax forecast and seem to be confusing myself......

If I sell $10k in mutual funds next year and all of the funds sold have been held for more than a year, they fall under long-term capital gains. Since our gross income will be below $40k, the tax rate on those shares sold will be 0%.

Stupid question, but am I correct in stating that the long-term capital gains associated with the $10k in funds sold do NOT count toward our taxable income for the year?

[secondcor521]

No, you are not correct.  The LTCG will count towards taxable income and will show up on that line of your tax return (line 15 on the 2021 Form 1040; probably will be around that line in 2022).

When your tax is calculated on your taxable income, because of your particular combination of ordinary and preferenced income, those LTCG will probably be taxed at 0% (See line 16 on the 2021 Form 1040, and the associated qualified dividends and capital gains worksheet).

[bmjohnson35]

Thanks secondcor521.

Let's say we made $100k for the year.........does this mean the capital gains from the $10k referenced above would be taxed and the capital gains amount would also be added into our taxable gross income?  In other words, would it result in double taxation (capital gains tax and taxed as part of gross taxable income)?

[Wile E. Coyote]

Thanks secondcor521.

Let's say we made $100k for the year.........does this mean the capital gains from the $10k referenced above would be taxed and the capital gains amount would also be added into our taxable gross income?  In other words, would it result in double taxation (capital gains tax and taxed as part of gross taxable income)?

No, capital gains will not be taxed twice.  They are “taxable income” and they are taxed generally at a lower rate (sometimes 0%).

[secondcor521]

Thanks secondcor521.

Let's say we made $100k for the year.........does this mean the capital gains from the $10k referenced above would be taxed and the capital gains amount would also be added into our taxable gross income?  In other words, would it result in double taxation (capital gains tax and taxed as part of gross taxable income)?

Wile E. Coyote is correct.  There is no double taxation.

To expand a bit, you start with your gross income, which is your salary, interest, dividends, capital gains, and business income all added together.

You then subtract some adjustments to get to adjusted gross income.

You then subtract your standard or itemized deductions to get to taxable income.

You then calculate your tax due based on your taxable income.  If you have both ordinary income (like a salary or interest income) and preferenced income (like capital gains), these are separated out in a somewhat complicated worksheet, taxed individually at the appropriate rates and brackets, then the total taxes on all those parts is added together to determine your tax due.  The place I'm familiar with is the Qualified Dividends and Capital Gains Tax Worksheet, which you can google.  There's a similar one in the Schedule D instructions.

Bottom line though, is that the ordinary income is taxed, and the capital gains are taxed, but it is separate and not double counted.

[Nate79]

Note that capital gains are the gains: $$ sold - $$ purchase. If you sell $10k of mutual fund it's only the gains above the purchase price that is the income, not the full $10k.

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[bmjohnson35]

Thanks everyone. 

I am aware all of the $10k is not taxed.  It has run around 30-40% the last few times. 

Tax software is great, but it doesn't help you much to understand how things are calculated.

[RedmondStash]

This stuff is so complex. Here's how I think about it.

Picture two stacks of cash: regular income, and long-term capital gains. Now picture a mark on the wall two feet up.

Put the LTCG stack on top of the regular income stack. If both stacks are short, nothing sticks up above the mark on the wall. In that case, the LTCG stack is taxed at 0%. If one stack is tall enough, part of the LTCG stack will stick up above the mark, and be taxed at a higher rate.

Let's say $80k is how much total income you can have without LTCG being taxed.

You can have $40k of regular income and $40k of LTCG. No tax on the LTCG.

If you have $41k of regular income and $40k of LTCG, then $1k of the LTCG is taxed at 15%. Similarly, if you have $40k of regular income and $41k of LTCG, $1k of LTCG is taxed at 15%. It's the total combined income that matters in terms of how LTCG is taxed.

Regular income is always taxed at the same rate. But how much regular income you have affects how your LTCG is taxed, because LTCG is essentially added on top of your regular income.

This leads to a weird phenomenon where adding $1 of regular income can mean tax on that $1 and also tax on the $1 of LTCG that gets pushed up above that mark. So adding $1 of regular income can mean being taxed 12% on that dollar and also 15% on a second $1 of LTCG (ETA: if you had some LTCG that would otherwise have been taxed at 0%).

Very weird stuff. Very worth understanding.