Are Capital Gains Taxes Marginal or Fixed and How to Plan Your Investments

Capital gains taxes can be a complex and intimidating topic, but understanding the basics can help you make informed investment decisions. Marginal capital gains taxes apply to individual investments, meaning you pay taxes only on the gains from each investment, not on the overall portfolio.

The good news is that marginal capital gains taxes are not fixed, but rather depend on the tax bracket of the individual investor. This means that as your investment portfolio grows, you may be able to take advantage of lower tax rates.

In the US, for example, the tax rates on long-term capital gains are 0%, 15%, or 20%, depending on the taxpayer's income level. This can impact the after-tax returns on your investments, making it essential to consider tax implications when planning your investments.

By understanding how marginal capital gains taxes work, you can make more informed decisions about when to buy and sell investments, and potentially reduce your tax liability.

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Capital gains taxes are a type of tax you pay on investments that increase in value.

You make a capital gain if you sell an investment for more than the cost to acquire it. This means you need to include all capital gains in your tax return in the year you sell the investment.

Capital gains are taxed at your marginal rate, which is the highest tax rate you pay on your income.

If you've held the investment for more than 12 months, you're eligible for the capital gains tax (CGT) discount, which means you're only taxed on half of the capital gain.

The ATO has information to help you work out your capital gains tax on different investments.

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Tax rates on capital gains can be complex, but there are some key points to keep in mind. For taxable years beginning in 2023, the tax rate on most net capital gain is no higher than 15% for most individuals.

A capital gains rate of 0% applies if your taxable income is less than or equal to $44,625 for single and married filing separately, $89,250 for married filing jointly and qualifying surviving spouse, and $59,750 for head of household.

The tax rate on capital gains can also be affected by your overall taxable income. A capital gains rate of 15% applies if your taxable income is more than $44,625 but less than or equal to $492,300 for single, $276,900 for married filing separately, $553,850 for married filing jointly and qualifying surviving spouse, and $523,050 for head of household.

If your taxable income exceeds these thresholds, a capital gains rate of 20% may apply. However, there are some exceptions where capital gains may be taxed at rates greater than 20%, such as selling section 1202 qualified small business stock, collectibles, or section 1250 real property.

Here's a summary of the tax rates on capital gains:

It's worth noting that long-term capital gains can be taxed at 0% if you're in the 12% ordinary income tax bracket. This means that if you have a long-term capital gain and your ordinary income is $5,000 under the 22% tax bracket, you'll pay 0% tax on the first $5,000 of the gain.

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Investment income includes interest, dividends, rent, managed funds distributions, and capital gains from property, shares, and cryptocurrencies. You pay tax on investment income at your marginal tax rate.

You can use a capital loss to reduce capital gains made in the year the loss occurs or carry forward the loss to offset future capital gains. For example, if you make a capital loss of $1,000 and have a capital gain of $1,500, you can deduct the loss from the gain, leaving you with a profit of $500.

Here are the tax thresholds for the Net Investment Income Tax (NIIT):

Note that if your MAGI is above the applicable threshold, the 3.8% tax will be applied to the lesser of your total net investment income or the amount by which your MAGI exceeds the threshold.

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You may be subject to the Net Investment Income Tax (NIIT) if you have significant investment income. This tax is worth noting.

The NIIT is mentioned in Topic no. 559, but let's focus on how it affects your investment income. For instance, capital gains will drive up your adjusted gross income (AGI), which can have negative consequences.

As your AGI increases, you may lose eligibility for Roth IRA or deductible IRA contributions. This is because these contributions are phased out as your AGI rises.

Long-term capital gains, on the other hand, are taxed separately from your ordinary income. This means they won't push your ordinary income into a higher tax bracket.

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You can use a capital loss to offset future capital gains. This is a great way to reduce the tax you owe on your investments.

A capital loss occurs when you sell an investment for less than the cost to acquire it. For example, Savannah made a capital loss of $1,000 when she sold shares for $20 per share after buying them for $40 per share.

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You can carry forward a capital loss to offset future capital gains. This can be especially helpful if you have other investments that have gained in value.

Here are some key things to know about capital losses:

If you make a capital loss, you can deduct it from your capital gains for the year. For example, Savannah was able to deduct her $1,000 capital loss from her $1,500 capital gain, leaving her with a profit of $500.

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A tax-effective investment is one where the tax on your investment income is less than your marginal tax rate. This is a great way to keep more of your hard-earned money.

One way to achieve tax-effective investments is to consider investments that generate tax-deductible income, such as rental properties. You can claim deductions on expenses like mortgage interest, property maintenance, and council rates.

Tax-effective investments can also help you manage your tax liability. By investing in a tax-effective way, you can reduce your taxable income and lower your tax bill.

The government receives a modest portion of its individual income tax revenues from capital gains taxes, averaging about 9 percent per year over the past two decades, totaling $137 billion or 0.7 percent of GDP.

Capital gains revenues have historically been volatile, reflecting changes in economic activity, especially during recessions. For example, revenues dropped 41 percent from $100 billion in 2001 to $58 billion in 2002.

In contrast, during the pandemic-related recession in 2020, capital gains revenues increased by 10 percent, and 64 percent in 2021, partially due to a strong stock market.

Modifications to capital gains taxation, such as the reduced tax rate and stepped-up basis, result in significant tax expenditures, exceeding the amount of revenues the government brings in from the tax by nearly 50 percent in 2023, totaling $361 billion.

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Capital gains taxes account for a modest portion of individual income tax revenues, averaging about 9 percent of such collections over the past two decades.

These revenues have historically been volatile, reflecting changes in economic activity, especially during recessions. For example, revenues dropped from $100 billion in 2001 to $58 billion in 2002, a 41 percent decrease in just one year.

The federal government receives a significant portion of its revenue from individual income taxes, including capital gains, which totaled $137 billion in 2023, or 0.7 percent of gross domestic product (GDP).

However, the amount of tax expenditures from capital gains has exceeded the amount of revenues the federal government brings in from the tax. In 2023, such expenditures totaled $361 billion.

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If you're temporarily unemployed, you may be able to take advantage of tax planning opportunities by coordinating your capital gains and ordinary income taxes.

This can be particularly useful if you're between 55 and 70 and looking to transition into retirement or are already retired.

You can also use this strategy if you work in sales and your salary varies from year to year.

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Selling a real-estate investment for a loss can also create opportunities for tax planning.

If you sell appreciated stock or mutual funds to meet your living expenses in a low-tax year, you'll have the opportunity to convert some of your pre-tax retirement accounts in the lower ordinary income brackets.

Here are some scenarios where income coordination can help:

Capital gains taxes can be a significant burden on investors, especially when it comes to short-term gains. In fact, the short-term example in our article shows that taxes owed on capital gains can be as high as $17,500 for a married couple with a MAGI of $500,000.

The impact of capital gains taxes on long-term investments is also noteworthy. For instance, if you sell 500 shares of stock at $200 each more than a year later, you'll owe $7,500 in taxes on capital gains, regardless of your MAGI.

Here's a breakdown of the total capital gains tax obligation for different income tax brackets:

As you can see, the total capital gains tax obligation increases with income, but the tax rate remains the same at 15% for MAGI of $150,000 and $300,000, and 20% for MAGI of $600,000.