Selling taxable investments held for more than a year has tax implications. Long-term gains from the sale of stocks, mutual funds and other capital assets are taxed favorably at 0%, 15% or 20% compared with the top 37% tax rate on ordinary income.
These rates for long-term capital gains are based on set income thresholds that are adjusted annually for inflation. For 2020, the 0% rate applies to taxable income of up to $40,000 on single returns, $53,600 for head-of-household filers and $80,000 for joint filers. The 20% rate starts at $441,451 for single filers, $469,051 for heads of household and $496,601 for joint filers. The 15% rate is for taxable incomes between the 0% and 20% break points. These rates also apply to qualified dividends. Short-term gains from the sale of assets held for a year or less are taxed at ordinary income rates.
Single taxpayers with modified adjusted gross incomes over $200,000 and joint filers over $250,000 owe a 3.8% surtax on net investment income, on top of the 15% or 20% capital gains rate. The surtax is due on whichever is smaller: NII or the excess of modified AGIs over the set income thresholds. NII includes, among other things, taxable interest, dividends, gains, passive rents, annuities and royalties.
For 2020, if taxable income other than long-term capital gains or dividends does not exceed $40,000 for singles or $80,000 for joint filers, then dividends and long-term capital gains aren’t taxed until they push you over those thresholds. Here are three scenarios to illustrate the rules. In the three examples, we have a married couple with $12,500 of qualified dividends and long-term capital gains, which are included in taxable income. In the first example, the couple has $65,000 of taxable income. The full $12,500 of gains and dividends are taxed at 0%. Now assume the couple has taxable income of $86,000; $6,500 of the gains and dividends ($80,000 – ($86,000 – $12,500)) is taxed at 0%, and $6,000 is taxed at 15%. If the couple instead has $110,000 of taxable income, the 0% rate doesn’t apply, and the full $12,500 of gains and dividends is taxed at 15%.
A few notes of caution: Gains and dividends taxed at 0% do raise your adjusted gross income. Also, your state income tax bill may rise, as many states tax gains as ordinary income.
New Proposals for Taxing Capital Gains
You may have heard about indexing capital gains for inflation. This intriguing concept, which has been bandied about for decades, has gained steam recently. Here’s how it would work: Taxpayers would be able to increase their tax basis for capital assets by the rate of inflation between the purchase and sale dates. Say you bought stock in early 2012 for $20,000 and sold it for $35,000 in early 2020. Using one inflation measure supporters have proposed, the GDP deflator index, your $20,000 original cost basis would jump to $22,860. Absent indexing, you would have a $15,000 capital gain ($35,000 – $20,000). With indexing, your gain is $12,140 ($35,000 – $22,860).
Capital gains indexing has lots of complexities, starting with choosing the appropriate inflation index. Also, tax basis isn’t always static, so adjusting for inflation gets tricky. Though Congress has no stomach to enact capital gains tax relief now, don’t be surprised if Donald Trump’s re-election campaign supports indexing or some other form of capital gains tax relief.
Joe Biden has a different idea for taxing capital gains. He wants to increase the tax rates for the wealthy. His plan would tax capital gains as ordinary income for filers earning over $1 million. He also wants to raise the top ordinary income tax rate back to 39.6% for people making more than $400,000. As a result, under his tax plan, filers reporting over $1 million in income could pay a 43.4% federal tax rate on their long-term capital gains compared with 23.8% now.
Gallery: 20 Steps to a Million-Dollar 401(k) (The Motley Fool)