Investors with taxable accounts—as opposed to tax-favored retirement accounts such as individual retirement accounts or 401(k)s—are often eligible for lower tax rates and other benefits.
When an investor sells a holding in a taxable account, the result is a capital gain or loss. That is the difference between the investment’s original cost (plus adjustments) and its selling price. If an investor buys a share for $3 and sells it for $5, the capital gain is $2. If that person buys another share for $3 and sells it for $2, the capital loss is $1.
A key benefit is that capital losses can offset capital gains. If the investor in this example sells both shares in the same calendar year, he or she would have a net taxable capital gain of $1 after combining the $2 gain and the $1 loss. If total losses exceed total gains, the net losses can offset up to $3,000 of “ordinary” income such as wages a year.
Another benefit is that unused capital losses can be carried forward to offset future capital gains and ordinary income. Long-term capital gains are profits on investments held longer than a year. They are taxed at favorable rates of 0%, 15% or 20%.
Short-term capital gains are those on investments held a year or less. They are taxed at the higher rates that apply to ordinary income. This is an important distinction frequent traders should be aware of.
Dividends and the 3.8% surtax
The favorable lower rates for long-term gains also apply to dividends that are “qualified,” which are most of them. Other dividends are taxed at the higher rates for ordinary income like wages.
However, a 3.8% surtax applies to net investment income for most single filers with adjusted gross income (AGI) above $200,000 and most couples filing jointly with AGI above $250,000. This surtax applies only to the amount of net investment income above those thresholds, which aren’t indexed for inflation.
For example, say that a single taxpayer has earned income such as wages and bonus totaling $150,000, plus a $60,000 taxable capital gain and $20,000 of dividends. This filer would owe the 3.8% tax on $30,000, which is the amount of his AGI above $200,000.
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Because of the surtax, top-bracket taxpayers typically owe 23.8% instead of 20% on their long-term gains and dividends. Some investors in the 15% bracket for this income owe the 3.8% surtax on part or all of it because their adjusted gross income is above the $250,000/$200,000 thresholds.
Here’s another example. Say a single filer has $210,000 of adjusted gross income, and $50,000 of that is a windfall from a long-term gain on an investment and qualified dividends. In that case, all this taxpayer’s investment income would be taxed at a 15% rate. He or she would also owe an additional 3.8% on $10,000 because that is the amount exceeding $200,000. So the rate on the $10,000 would be 18.8%.
How the zero rate applies
Here is a simplified example. Say that Janet is a single taxpayer with $30,000 of taxable ordinary income for 2021 after deductions and exemptions, such as for tax-free municipal-bond interest. Her taxable income is subject to rates up to 12%, as detailed in the income-tax brackets.
But Janet also has a $20,000 long-term capital gain. This “stacks” on top of her $30,000 of taxable income, giving her total taxable income of $50,000. For 2021, the 15% bracket for capital gains begins at $40,401 of taxable income for single filers. As a result, Janet would owe zero tax on about $10,400 of her gain and 15% on about $9,600 of it.
This year’s tax deadline for most individuals is April 18. Interested in knowing more before you file your taxes? Register here to read the WSJ Tax Guide 2022.
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