Confused by interplay of capital gains and taxable income

[Austin704]

I understand that LTCGs are subject to more favorable tax rates than ordinary income, and that realizing long-term capital gains does not cause ordinary income to be taxed at a higher rate. But looking at Form 1040 it appears that LTCG are included in total income, AGI, and taxable income after deductions.

Schedule D instructs to add short- and long-term gains (or losses) and to enter that amount on line 7 capital gains, which is then included in total income. Total income is then adjusted, but AGI appears to include the capital gains. Likewise, when deductions are made, they are made to AGI and the capital gains appear to carry through all the way to line 15 taxable income.

When I look at the tax tables, I see no distinction made for LTCG vs ordinary income. Ordinary income taxes key off line 15, taxable income.

So, if taxable income includes capital gains, and those gains push my taxable income into a higher tax bracket, and taxes owed are figured on those brackets, where's provision that then separates out the LTCG from taxable income?

Another way of asking this is where on Form 1040 is the place where LTCGs are separated from ordinary income for tax purposes?

 

[cathy63]

In the 1040 instructions for line 16, you will be directed to use the Schedule D worksheet or the QDiv/Cap Gains worksheet to calculate your tax if applicable. Those worksheets will treat the LTCGs properly.

 

[pb4uski]

The rates have changed since this was written, but the principles are still the same.

https://www.kitces.com/blog/underst...st-capital-gains-for-a-free-step-up-in-basis/

 

[FANOFJESUS]

This has helped me a great deal.
https://engaging-data.com/tax-brackets/?fs=0&reg=0&cg=55000

 

[Midpack]

This has helped me a great deal.
https://engaging-data.com/tax-brackets/?fs=0&reg=0&cg=55000

+100. That’s awesome, thanks for highlighting it, I’d never seen it. Here’s a fictitious example to tempt others to give it a look.

 

[pb4uski]

+1 Nice display of how it works.

 

[clobber]

So, if taxable income includes capital gains, and those gains push my taxable income into a higher tax bracket, and taxes owed are figured on those brackets, where's provision that then separates out the LTCG from taxable income?

Another way of asking this is where on Form 1040 is the place where LTCGs are separated from ordinary income for tax purposes?

I think you got it right. Captal Gains do get added into your AGI and taxable income. However, they get pulled back out when actually calculating the tax owed.

In the 1040 instructions for line 16, you will be directed to use the Schedule D worksheet or the QDiv/Cap Gains worksheet to calculate your tax if applicable. Those worksheets will treat the LTCGs properly.

+1 - Specifically on the "Schedule D Tax Worksheet" :

1. Line 2 is where qualified dividends are pulled out
2. Line 7 is where LTCG is pulled out
3. Line 31 is where the 15% tax is calculated
4. Line 34 is where the 20% tax is calculated
5. Line 44 is where the normal tax on the rest is computed

 

[Austin704]

Thanks everyone for the great responses and graphics. This really helps me wrap my head around it conceptually, and also how it's addressed on the 1040 / Sch D.

I assume the inclusion of capital gains in AGI and taxable income has some bearing on determining the capital gains tax rate?

As I understand it, LTCGs are taxed at zero for single filers under $40,000 in taxable income. So for example if ordinary income is $35,000 and LTCGs are $10,000 total taxable income is $45,000 (after adjustments and deductions).

Should I assume that $5,000 of the LTGCs will be taxed at 0% and $5,000 taxed at 15% in this example?

Thanks again!

 

[RunningBum]

Yes, you've got it!

Probably a lot of the reason they are included in AGI is that other stuff based off of AGI or MAGI like the ACA subsidy is designed to be based on all income.

 

[Austin704]

Makes sense Running Bum. Thanks for the confirmation...

 

[SecondCor521]

Thanks everyone for the great responses and graphics. This really helps me wrap my head around it conceptually, and also how it's addressed on the 1040 / Sch D.

I assume the inclusion of capital gains in AGI and taxable income has some bearing on determining the capital gains tax rate?

As I understand it, LTCGs are taxed at zero for single filers under $40,000 in taxable income. So for example if ordinary income is $35,000 and LTCGs are $10,000 total taxable income is $45,000 (after adjustments and deductions).

Should I assume that $5,000 of the LTGCs will be taxed at 0% and $5,000 taxed at 15% in this example?

Thanks again!

Emphasis added.

You have the right idea. Just remember that the above is true for taxable ordinary income, which is ordinary income after making adjustments and subtracting (usually) the standard deduction. I think that's what your parenthetical comment meant, but I'm not 100% sure.

So in the most straightforward situation, a single person earning $35,000 + $12,550 on a job and having $10,000 in LTCG would be taxed as you describe above. (They'd also owe ordinary income taxes on the $35K, which would be a bit under $4,200 because they'd owe some at 10% and most at 12%.)

 

[Austin704]

Yes, I didn't articulate it well, but the example assumes $35,000 ordinary income and $10,000 in LTCG *after* all adjustments and deductions. The nominal ordinary income would be higher by the standard deduction of $12,400 for single filer.