If you’re investing successfully, then it might be nice to see the total value of those investments growing over time, but are you aware that significant growth can put you in a higher tax bracket? This is one way that many people end up owing a lot more tax than they anticipate. Long-term capital gains can’t push you into a higher tax bracket, but short-term capital gains can. Understanding how capital gains work could help you avoid unintended tax consequences. If you’re seeing significant growth in your investments, you may want to consult a financial advisor.
How Tax Brackets Work
Let’s understand how tax brackets work. You can consider them to be like a series of fiscal steps: The more you earn, the higher you climb; and consequently, the higher the tax rate is that you pay.
For example, as of 2023 in the US, if you make up to $11,000, you’re on the first bracket tier, taxed at 10%. However, if your income surpasses $578,125, you’re on the topmost tier, taxed at an imposing rate of 37%.
Your tax bracket will depend on how much money you’ve made for the year and what your tax filing status is when you file. As another example, at the 10% tax tier discussed above for 2023, if you’re married and file your taxes jointly then you could earn up to $22,000. The high-end tax tier for those filing jointly also is extended to $693,750.
Appreciating the concept of tax brackets and identifying where you stand is vital as it directly influences your tax liability and overall financial planning. There are also many ways to lower your tax bracket with credits or deductions that can lower your taxable income. Remember that your tax bracket only relates to your taxable income, not necessarily all income that you received for the year.
What Qualifies as a Capital Gain?
Now, let’s shift our focus to capital gains to better understand how these work. Capital gains are the net increase of your investments, meaning what you make above what you spend to purchase that investment. For example, suppose you purchased a stock for $50 and sold it later for $100. The additional $50 you earned is your capital gain.
These gains, profits from your investments or sale of assets like stocks, bonds or property, come under the purview of the capital gains tax. The IRS taxes capital gains in two ways: Long-term and short-term capital gains. Assets held for more than one year before selling qualify as long-term, and are taxed at a relatively lower rate. Conversely, if you sell within a year of purchasing, you’re subject to a higher tax rate on the short-term capital gain.
Income Tax vs. Capital Gains Tax
Gains from your investments aren’t the only income taxed. Taxing authorities scrutinize all of your income, from earned employment income to investment dividends. All of your owed tax together on your combined income is your income tax obligation. Your capital gains tax isn’t included as part of your total income tax requirement but might be taxed similarly.
The income tax is what is referred to within the tax brackets above. A short-term capital gains tax is taxed at the same tax brackets, but long-term capital gains are taxed at 0%, 15% or 20%. The amount you pay on those capital gains depends on your specific income and tax filing status.
These income limits are different than the normal income tax brackets, though. For example, if you’re a single filer you can earn up to $41, 675 before paying any tax on these capital gains and up to $83,350 if you’re married filing jointly.
What Is the Capital Gains Bump Zone?
The capital gains bump zone refers to the range of income where a substantial capital gain could tip you into a higher tax bracket, and therefore increase your tax rate.
For example, if you’re residing in the 22% tax bracket and a $10,000 capital gain inflates your income to enter the 24% tax bracket, you’ll end up paying a higher tax rate on the portion of income in the 24% bracket. A clear understanding of this dynamic can help you anticipate and prevent potential tax pitfalls.
Tips for Lowering Your Capital Gains Tax
While lowering your capital gains tax may seem challenging, various strategies can come to your rescue. You may consider holding onto your assets for over a year to qualify for lower tax rates on long-term capital gains.
Offsetting capital gains with losses or investing in tax-advantaged accounts like individual retirement accounts (IRAs) or 401(k) plans can also prove beneficial, depending on your specific financial situation.
Fortunately, a financial advisor can guide you in crafting a customized tax strategy to help manage and reduce your capital gains tax efficiently.
Bottom Line
Knowing when capital gains could trigger additional taxes by pushing you into a higher tax bracket is key for your investment portfolio. That’s why you should take note: While long-term capital gains can’t push you into a higher tax bracket, short-term capital gains could.
Tips for Tax Planning
Getting pushed into a higher tax bracket can be devastating for you if you’re not prepared for it. Plus, there may have been plenty you could do to avoid that higher tax. An experienced financial advisor who specializes in tax strategies could help you prepare for all of these things and help you manage your finances. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you canhave a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you anticipate receiving some capital gains this year, you can use SmartAsset’s free capital gains calculator to help you estimate what you might owe.
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