Calculating your long-term capital gains tax when you have active income can be very confusing. Therefore, I'd like to clarify the confusion with the following examples.
Short-term capital gains is making money from selling assets held under one year. Long-term capital gains is making money from selling assets held over one year. Hence, before you sell any asset held for less than a year, calculate your estimated net proceeds after tax expenses.
Long-Term Capital Gains Tax Example #1
Say you bought ABC stock on March 1, 2010, for $10,000. On May 1, 2023, you sold all the stock for $20,000 (after selling expenses). You now have a $10,000 capital gain ($20,000 – 10,000 = $10,000).
If you’re single and your income was $80,000 for 2023, you would be in the 15 percent long term capital gains tax bracket. In this example, that means you would pay $1,500 in capital gains tax ($10,000 X 15 percent = $1,500).
That amount is in addition to the tax on your ordinary income. Your $80,000 of ordinary income would be taxed at 10% on income up to $11,000, at 12% on income from $11,001 to $44,725, and 22% on income between $44,726 to $95,375.
In other words, even if there is a 0% long-term capital gains tax rate on up to $44,625 in stock sales, dividend income, property sales, etc, you still have to pay a long-term capital gains tax on your $10,000 capital gains.
Some people are confused and think you can make any amount of ordinary income (active income) and still pay the long-term capital gains tax rate independently. In actuality, you must add up your ordinary income and long-term capital gains income and then pay the long-term capital gains tax rate accordingly.
See the short-term and long-term capital gains tax chart below for singles in 2023.
Long-Term Capital Gains Tax Example #2
What about a situation where you can pay 0% long-term capital gains tax? Here's an example.
Financial Samurai Jeff earned a $40,000 salary in 2023. He pays 10% on the first $11,000 income and 12% on the income he earned beyond that, up to $44,725 (40,000 – $11,000 = $29,000). His total tax liability is $4,580 ($1,100 + $3,480).
If Jeff sells an asset that produced a short-term capital gain of $2,000, then his tax liability rises by another $240 (i.e., 12% x $2,000). However, if Joe waits one year and a day to sell, then he pays 0% on the capital gain.
Why? Because his total income is $40,000 + $2,000, which is below the $44,625 threshold for single people to pay 0% long-term capital gains tax. Again, you need to total your ordinary income and long-term capital gains income to calculate what long-term capital gains tax rate to pay.
Long-Term Capital Gains Tax Example #3
Financial Samurai readers Stephanie and Derek, who are married, earn $1,000,000 in 2023. They pay a 37% marginal income tax rate on all income above $693,750 until $1,000,000. They pay the other marginal income tax rates on all income below $693,750.
Stephanie and Derek also have long-term capital gains of $88,000 from selling stock in 2023. Do they get to pay 0% long-term capital gains on the $88,000 since it is below the $89,250 threshold for 0% long-term capital gains tax for married couples? Unfortunately, no.
Given Claire and Hank are in the highest income tax bracket (37% marginal income tax on income over $693,750), their $88,000 will get taxed at a 20% long-term capital gains tax rate. In other words, they have to pay $17,600 on those capital gains.
The IRS wants its money. The IRS isn't going to let an already top 1% income-earning household then earn tax-free income of up to $89,250 for married couples. If so, that would be an obvious loophole every six-figure or top 1% income earner would pursue!
More Capital Gains and Ordinary Income Tax Clarification
Here are several more points of clarification I want to make regarding long-term capital gains tax and ordinary income tax.
Capital gains will increase your adjusted gross income (AGI). As your AGI increases, you begin to get phased out of itemized deductions, certain tax credits, and lose your eligibility for Roth IRA or deductible IRA contributions. Therefore, you need to be strategic about when to realize your capital gains (when to sell).
It's better to realize capital gains during low ordinary income years rather than high ordinary income years. In other words, a proper estimation of your passive investment income is important!
Also know that long-term capital gains are taxed separately from your ordinary income. Your ordinary income is taxed FIRST. In other words, long-term capital gains and dividends which are taxed at the lower rates WILL NOT push your ordinary income into a higher tax bracket.
The main difference is that the gains are taxed differently depending on whether they're short-term or long-term. Short-term capital gains are included in your ordinary income and therefore are taxed at ordinary income rates.
However, long-term gains are not considered ordinary income. They are considered long-term capital gains and receive a lower, preferential tax rate.
In other words, realizing long-term capital gains will not cause your ordinary income to be taxed at a higher rate.
Be Smarter About The Way You Earn Income
As you can see from the long-term capital gains tax examples above, it's more beneficial to earn more passive investment income from stocks, real estate, bonds.
Here are the top passive income investments ranked. It takes a long time to generate enough passive income to cover your living expenses. But if you do, you are financially free.
Eventually, you will run out of energy or ability to make ordinary income from your day job. When that day comes, if you've been diligently saving and investing, your passive income investments are what will take care of you.
Please note the differences between active income and passive income as well. You don't want to confuse active income sources as passive income sources. If you do, you'll end up frustrated and angry spending so much time and energy when you didn't plan to.
Ideally, the majority of your income comes from long-term capital gains and investment income. This way, you'll have the most freedom and earn the most bang from your buck!
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