Written by: Davis Barry
The current capital gains tax rate structure was created under the Jobs Growth & Tax Relief Reconciliation Act of 2003. It was extended in 2010 and made permanent under the American Taxpayer Relief Act of 2012. Below we will walk through how long-term capital gains are taxed and when the 0% capital gains tax rate applies.
The 0% capital gains tax rate applies to the bottom two marginal tax brackets of 10% and 15%, respectively. The 25%, 28%, 33% and 35% marginal tax rates have a 15% capital gains tax rate. The third and final capital gains tax rate is 20%, which applies to taxpayers who find themselves in the highest marginal tax bracket of 39.6%. What this means is that if your ordinary income falls within the 10% or 15% marginal tax bracket, then any realized long-term capital gains will be taxed at 0%. The corresponding capital gains tax rate will apply when ordinary income is within the higher marginal tax brackets. Capital gains tax rates are graduated just like ordinary income tax rates. Therefore, your effective capital gains tax rate may not be exactly one of the stated rates. It is important to mention that there is an additional Medicare surtax of 3.8% that is tacked on once you reach the highest marginal tax bracket and applies to any realized capital gains.
For example, lets say a married couple, filing their taxes as married filing jointly, has $50,000 in ordinary income (after their personal exemptions & taking the standard deduction) and $100,000 in realized long-term capital gains. The $50,000 in ordinary income puts the couple in the 15% marginal tax bracket for 2016, which applies to ordinary income between $18,550 – $75,300. Therefore, the first $25,300 of the realized capital gains ($75,300 less $50,000) will be taxed at the 0% long-term capital gains rate. The remaining $74,700 in long-term capital gains will fall in the 25% marginal tax bracket and therefore be taxed at the 15% capital gains tax rate.
While having the opportunity to pay a 0% capital gains tax rate, on some or all of your realized capital gains, can be very attractive, it is important to remember that realizing capital gains may affect eligibility for certain deductions and tax credits. Also, the realization of capital gains may adversely affect the taxation of social security benefits. The above scenario deals with realized long-term capital gains. Any security sold at a gain, but held for less than one year, is considered a short-term capital gain and does not receive the same preferential tax treatment.
Tax laws are always subject to change and the above example pertains to the 2016 tax year.