Tax Planning for a large Capital Gain

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Tax Planning for a large Capital Gain

by DonDraper » Wed Jun 19, 2013 9:30 pm

The new capital gains rates and how they are calculated is confusing the heck out of me. If someone has W-2 income that puts them solidly in the married filing joint 25% bracket(lets say 145k) and then you throw a large $700k long term capital gain on top of it. 

Will the $700k LTCG be taxed at 23.8% (20+3.8 Medicare tax)? Will then any of the w-2 wages be taxed in the 39.6% rate?

It's very confusing trying to figure out how all the layers of income get taxed and at what rate and in what order.

DonDraper

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Re: Tax Planning for a large Capital Gain

by grabiner » Wed Jun 19, 2013 10:52 pm

DonDraper wrote:The new capital gains rates and how they are calculated is confusing the heck out of me. If someone has W-2 income that puts them solidly in the married filing joint 25% bracket(lets say 145k) and then you throw a large $700k long term capital gain on top of it. 

Will the $700k LTCG be taxed at 23.8% (20+3.8 Medicare tax)? Will then any of the w-2 wages be taxed in the 39.6% rate?

It's very confusing trying to figure out how all the layers of income get taxed and at what rate and in what order.

Capital gains are taxed based on the income tax bracket the income is in, but at a lower rate. Thus, you pay 10%, 15%, and 25% income tax on your regular income, then 15% income tax on the difference between your regular income and the top of the 35% bracket, and 20% on the amount of income between the top of the 35% bracket and the total income. You also pay the 3.8% Affordable Care Act tax on the total income over the $250,000 threshold.

The tax effect may be somewhat higher because your large income may cause other benefits to phase out; for example, if you itemize deductions, your itemized deductions will be reduced. (On the other hand, if you pay state estimated tax on the capital gain, that will be deductible against your income.)

A good way to see the effect is to enter the capital gain in your tax software and see how things change.

 David Grabiner

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Re: Tax Planning for a large Capital Gain

by kaneohe » Thu Jun 20, 2013 12:20 am

I find it helpful to think of this in separate pieces. For the "normal" capital gain (and qual. dividend) calculation, the stacked bar chart concept of a bar of (LTCG/QDIV) sitting on top of a bar of ordinary income (less deductions/exemption) since you are looking at taxable income is helpful. See the chart by tfb herehttp://www.bogleheads.org/forum/viewtopic.php?f=10&t=86849......dated Dec. 11. The ordinary income is taxed by itself after the bar of LTCG/QDIV is removed so,
at least for the normal tax, the LTCG/QDIV does not affect taxation of the ordinary income (AMT may be different since the
large LTCG reduces the AMT exemption and leads to AMT , at least using 2012 models).
The ordinary income, on the other hand, elevates the LTCG/QDIV bar into higher tax brackets and does affect their taxation.

You can extend this stacked bar chart concept to the 2013 capital gains rates where 3 different rates are involvedhttp://fairmark.com/atra-capital-gain-tax-rates/. Note that these bar charts involve taxable income and their tax brackets.

The 3.8% Medicare tax on investment income seems to be a separate concept and is based on AGI (assuming no foreign earned income), not taxable income. http://fairmark.com/medicare-tax-on-investments/ . I don't know what the tax form will be like but I would guess it would be a separate calculation from the LTCG/QDIV calculation esp. since it is based on AGI (or investment income) and not taxable income.

If these changes are 2013 changes rather than 2012, you may not see them reflected in current tax software until near year end.

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Re: Tax Planning for a large Capital Gain

by livesoft » Thu Jun 20, 2013 12:44 am

Doesn't TaxCaster (online tax calculator) account for all this stuff nowadays? Have you tried it to estimate the taxes?

This information has been prepared without taking into account the Sequestration, investment objectives, financial situation and particular needs of any particular person or company.

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Re: Tax Planning for a large Capital Gain

by DonDraper » Thu Jun 20, 2013 6:35 am

grabiner wrote:

DonDraper wrote:The new capital gains rates and how they are calculated is confusing the heck out of me. If someone has W-2 income that puts them solidly in the married filing joint 25% bracket(lets say 145k) and then you throw a large $700k long term capital gain on top of it. 

Will the $700k LTCG be taxed at 23.8% (20+3.8 Medicare tax)? Will then any of the w-2 wages be taxed in the 39.6% rate?

It's very confusing trying to figure out how all the layers of income get taxed and at what rate and in what order.

Capital gains are taxed based on the income tax bracket the income is in, but at a lower rate. Thus, you pay 10%, 15%, and 25% income tax on your regular income, then 15% income tax on the difference between your regular income and the top of the 35% bracket, and 20% on the amount of income between the top of the 35% bracket and the total income. You also pay the 3.8% Affordable Care Act tax on the total income over the $250,000 threshold.

The tax effect may be somewhat higher because your large income may cause other benefits to phase out; for example, if you itemize deductions, your itemized deductions will be reduced. (On the other hand, if you pay state estimated tax on the capital gain, that will be deductible against your income.)

A good way to see the effect is to enter the capital gain in your tax software and see how things change.

Thank you. I think I understand completely. It seems in the year this 1 time gain would happen it would wise to max out all 401k's because the marginal rate of that additional dollar is: 25% ordinary + 5% LTCG(20-15) + 3.8% med surcharge = 33.8%. 

If you think of it as stacked income with the gain on top, additional 401k contribution slides the whole upper stack down causing less dollars in the 20% LTCG bracket and less dollars subject to the 3.8% surcharge. Sound right?

DonDraper

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