Do Capital Gains Affect Your Tax Bracket?

Understanding the difference between ordinary income and capital gains (both long and short term) and how these affect each other can be confusing. As an investor, you can benefit from managing your tax obligations. A clear explanation of tax brackets is a good starting point.

The U.S. Federal government taxes income progressively, with higher percentages applied to higher income levels. That means that if you earn $30,000 annually and your friend Joe earns $100,000, you both pay the same rate on that first $30,000, but Joe will pay a higher rate on the portion of his income that falls in a higher bracket. Currently, there are seven brackets, and within those brackets, different rates apply depending on the taxpayer's filing status. For example, the 10% rate applies to a single filer with up to $10,275 in income, but for a married couple filing jointly, the rate applies to income up to $20,550.

For 2022, these are the tax bracket thresholds:

These rates include income from wages and salary, plus bonuses and commission, self-employment, interest and dividends, and royalties, but not capital gains.

What are capital gains, and how are they taxed?

A capital gain results from selling an asset for more than its basis (which is what you paid for it, plus some adjustments). Whether and how much you pay in taxes on the gain depends on several variables. The first is timing. The gain is called short-term if you owned the asset for less than a year. For example, suppose you buy stock in XYZ Company for $1,000 and hold it for six months, then sell it for $2,000. That profit is a short-term capital gain; you will owe taxes at your ordinary income rate, depending on your income level.

If instead, you own the stock for 12 months before selling, the gain is considered long-term. In that case, the tax rate will be lower, depending on your income level. The brackets for 2022 are:

Capital gains can affect your AGI

While capital gains do not affect your income or income tax bracket, those gains can impact your Adjusted Gross Income. The IRS explains that AGI consists of “…gross income minus adjustments to income. Gross income includes your wages, dividends, capital gains, business income, retirement distributions, and other income. Adjustments to income include such items as Educator expenses, Student loan interest, Alimony payments or contributions to a retirement account.” AGI is considered when determining eligibility for certain credits, like the Saver’s Credit and Child Tax Credit. It also determines whether you can take certain deductions, such as for medical expenses.

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^{Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.}

^{Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.}