Show Notes

• (00:55) Capital Gains Tax Vs. Ordinary Income Tax (Cole, Air Force)
• (09:19) $10K Ordinary Income, $40K Qualified Capital Gains. In What Tax Bracket is the $10K? (Mike, Akron, OH)
• (14:22) Tax Planning and Roth Conversions: Itemized Deductions, Dividends, and Long-Term Capital Gains (David, NYC)
• (23:10) Taxes on Dividends Collected Vs. Dividends Reinvested (Smitty, Roseburg, OR)
• (28:44) Dividends and Long-Term Capital Gains – Part 3 (Smitty, Roseburg, OR)
• (32:31) Capital Gains “Sit On Top” of Income? What About When Doing Roth Conversions? (Stever, Coronado, CA)
• (38:56) Confirming How Capital Gains Are Stacked on Top of Ordinary Income (Susan, Atlanta)
• (43:20) TSP to Roth IRA Conversion: Long-Term Capital Gains vs. Ordinary Income? (Tim)
• (48:19) What Does “Capital Gains Ride on Top” Mean? (Jim, Santa Cruz, CA)
• (50:37) Selling CDs in a 401(k): Capital Gains or Ordinary Income? (Dr. James, Serra Mesa, CA)

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WATCH | YMYW TV: Take the Sting Out of Taxes for High-Income Earners: Tax Loss Harvesting and Other Strategies

WATCH | How to Pay a 0% Capital Gain Tax Rate

PREVIOUS CAPITAL GAINS AND ORDINARY INCOME EPISODES

• LISTEN | YMYW PODCAST #318: Clarification on Capital Gains vs. Ordinary Income
• LISTEN | YMYW PODCAST #303: Confirming How Capital Gains are Stacked On Top of Ordinary Income
• LISTEN | YMYW PODCAST #295: Capital Gains “Sit On Top” of Income? What About When Doing Roth Conversions?
• LISTEN | YMYW PODCAST #292: Dividends and Long Term Capital Gains – Part 3
• LISTEN | YMYW PODCAST #287: Tax Planning and Roth Conversions: Itemized Deductions, Dividends, and Long Term Capital Gains
• LISTEN | YMYW PODCAST #272: $10K Ordinary Income, $40K Qualified Capital Gains. In What Tax Bracket is the $10K?

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Transcription

Today on Your Money, Your Wealth® podcast #325, you have asked many times for clarification on how long term capital gains are stacked on top of ordinary income, so here are all of those discussions in a single episode for easy reference. And in the podcast show notes at YourMoneyYourWealth.com you’ll find resources to help you pay less capital gains tax. Just click the link in the description of today’s episode in your podcast app to go to the show notes. You may have noticed, Congress is making major changes that may impact your retirement and how much you’re paying in tax. Stay a step ahead with a free assessment of your overall finances from a CERTIFIED FINANCIAL PLANNER professional. Click the Get an Assessment button at YourMoneyYourWealth.com to get started. I’m producer Andi Last, and here are the hosts of Your Money, Your Wealth®, Joe Anderson, CFP® and Big Al Clopine, CPA, with your cap gains   vs. ordinary income tax compilation.

Capital Gains Tax vs. Ordinary Income Tax (Cole, Air Force)

Joe: So we actually got a voice recording. Who do we got?

Cole: Hello, my name is Cole and I was just calling to ask you a question for the podcast. So, I haven’t really listened for too long, I mostly just started like about a week ago, but I’ve listened to about 10 or so, so far just on my way to work, in my black Hyundai Elantra.

So right now, I have a lot of money that I’ve been investing into a Roth IRA and into my TSP, also in Roth, because I’m in the Air Force. But I was wondering, I wanna start investing even more than the maximum contributions for both Roth TSP and my Roth IRA, which I’m currently maxing out both. And I want to start contributing to my own brokerage account through Vanguard.

So, I was wondering how that works with capital gains tax with your regular tax. So, for example, if I make $50,000 a year now, and I make let’s say $20,000 worth of capital gains tax, I know that it’s a separate tax rate, but does it affect the $50,000 that I currently make on the bottom or on the top?

And what I mean by that is like if I make $50,000 a year and let’s say that that was theoretically taxed at 20% versus if I was bumped up to $70,000, then taxed at 25% because of that, does come to the bottom or the top?

That made no sense but hopefully, you get the idea of what I’m saying because I didn’t really and I just kind of called off the cuff. So thank you so much I appreciate it and I love watching the podcast – well, listening to it – and have a wonderful day.

Joe: Awesome. I know exactly what Cole is talking about.

Al:  I do too. Let’s explain it.

Joe: Because- Well first of all Cole thank you for your service. And thank you for letting us know what kind of car you drive because that just made us feel like we were going-

Andi: We don’t know where he is.

Joe: Yeah, where the hell are ya Cole? Where are you driving your Hyundai Elantra?

Al: He’s in the Air Force.  He’s in the air all the time.

Joe: He’s flying. He’s Maverick.

Al: Anyway. I know what he’s asking too. But you go ahead.

Joe: So when he’s asking is it on the top or the bottom- because a capital gain has a different tax rate. It could be zero, could be 15% or could be 20% depending on what your adjusted gross income is or what your taxable income is. What he’s saying is that I make $50,000 a year of ordinary income. And if I have $20,000 of capital gains does the capital gains start at the bottom and then all of a sudden push my $50,000 up into the higher tax brackets? Or does the $50,000 stay? And let’s say he’s taxed at a little bit at 10% and a little bit at 12%. And then do the capital gains sit on top of the $50,000? And then from there, those are taxed at capital gains rates. So he can use the bottom brackets the 10% and the 12% or the 22% bracket with ordinary income and then would the additional capital gains sit on top of that? So it doesn’t push his other income into those higher brackets.

Al: Yeah that’s exactly the question.

Andi: Now I actually understand it. I did not know what he meant.

Joe: Is it up or bottom? Is it in? Is it out?

Al: And Cole, you’re going to like the answer because the capital gains always sit on top of ordinary income. So it does not push the ordinary income up into a higher bracket. So let’s just use your numbers of $50,000. Let’s say you’re single. We don’t know that for sure but let’s just say you’re single. So if you make $50,000 a year and with a standard deduction of about what, $12,000 that puts you about $38,000 taxable income which is about the top of the 12% bracket. So that means your salary is going to be- you’re going to pay 10% and 12% regardless of how many capital gains that you have. Now your capital gains sit on top and because your capital gains would effectively push you into the next bracket, which is the 22% bracket. Those are taxed at 15%. So your ordinary income is taxed at the lower brackets. The capital gains because you’re above that 12% bracket is taxed at the capital gains rate of 15%.

Joe: And then plus the state which you didn’t give us.

Al: Well he’s in the air. So it changes.

Andi: In his Elantra.

Joe: It changes. I have a question for you. Because if Cole stays in the 10% or 12% tax bracket, then the capital gains is actually tax-free. So let’s say he’s married now.

Al: OK perfect. So now let’s just say married. And that’s all the income they make and they get it- they double up on the standard deduction. So I’m just going to say it’s $30,000 taxable income just to be simple. And the top of the 12% bracket is about $80,000. Which means now Cole, you could have $50,000 of capital gains to get to that $80,000. And now since you’re in, even combined, on a 12% bracket, the capital gains are tax-free, as long as they’re long-term. And a lot of people don’t realize this. When you’re in the lowest two tax brackets, 10% and 12%, capital gains rate is zero at least for federal, not for the state, but at least for federal. And some people ask me, my taxable income is $79,000. So what if I have $100,000 capital gain? Is that all tax-free? No. Only $1,000 of it to get you to the $80,000. Everything else then is at 15%.

Joe: So on the other side though too, because your tax bracket is so much higher because he had that $100,000 capital gain even though your taxable income of ordinary income is still in the 12% tax bracket. People get a little bit confused there as well. It’s like oh well now do I still get at least the $1000 tax-free? Just because my taxable income is so much higher because of all of the capital gains that I receive. But you would still get the $1000 tax-free.

Al: Yeah you would. And so for tax geeks out there let me give you the formula. So figure out your ordinary income and your ordinary deductions like your standard deduction. That’s your ordinary tax. Look at the tax table, figure the tax. Then you add your capital gains on top of that at capital gains rates to figure out what that is.

Joe: How about this? So there’s that net investment income tax comes in right at $200,000 single; $250,000, if I’m married.

Al: And that’s adjusted gross income.

Joe: Adjusted- AGI. And so let’s say that I have $251,000 of adjusted gross income. $100,000 of that was capital gains. So does $1000 dollars get the additional net investment income tax? Or does the entire $100,000 get the 3.8%?

Al: Yeah. Just $1000, if you’re married. Because it’s $250,000. Everything above $250,000- so it’s the lower of the excess amount or the passive income; in this case the capital gains, the passive income. Now if you’re single and the floor is $200,000 and you were at, what did you say? Like $256,000? So then $56,000 is subject to the 3.8% tax, but not the whole $100,000.

Joe: So with just about every tax situation, let’s say if I had a taxable income of $100,000 and I would be- if I was married, let’s say, I’d be in the 22% tax bracket. So some people think, well then all of my income is taxed at 22%.

Al: So I pay $22,000 to the feds.

Joe: But it’s stair steps. A little bit is taxed at 10% and this and that. And once I’m in that bracket, that’s all I’m paying tax on. The same thing is true for capital gains. The same thing is true for net investment income tax. So once you break those thresholds then the only the additional above those thresholds would be taxed at those different rates.

Al: That’s exactly right. And the IRS generally tries to do that so you’re not penalized for going $1 over and have all this giant extra tax. There are exceptions though.

Joe: Yes. What?

Al: One is the ACA credit.

Joe: Medicare premiums.

Al: Yeah. And Medicare. And Social Security taxability. So there are some exceptions there.

Joe: Anything else? Medicare. Social Security. Subsidies.

Al: Yeah. Subsidies. If you lose money on rental properties, you start- as you add income, you also lose losses at the same time. So yeah there are some problems. I’m forgetting the name of it- the 20% small business deduction-

Andi: QBI.

Al: Yeah. Thank you. QBI. Yeah, there are some cliffs there.

$10K Ordinary Income, $40K Qualified Capital Gains. In What Tax Bracket is the $10K? (Mike, Akron, OH)

Joe: Just like Mike did from A-kron, Ohio.

Andi: Akron.

Joe: A-kron. What do you call it?

Andi: Akron.

Joe: What did I say?

Andi: A-kron.

Joe: Oh, what’s the difference? I like the A. It sounds better than the ‘ah’.

Andi: Ok.

Al: I can see that.  It’s like Acorn. I mean it’s almost like that.

Joe: Akron? Does that sound better, Akron?

Al: That’s true. That’s what it’s called. I agree with Andi on this one. Which I usually do.

Andi: But yes, it sounds better Joe, so you know go with the aesthetics of it. Who cares what the town’s actually called.

Joe: A-kron. You say tomato, I say tomahto.

Al: OK. Good enough.

Joe: “If I made a $50,000 and $10,000 was ordinary income and $40,000 was qualified income taxed at 15%, I would be in the 12% tax bracket. $40,000 plus $10,000, at what percentage is the $10,000 taxed?” So the capital gains sits on top of your ordinary income Mike. So this is- we had another question a couple of weeks ago. So he’s got $10,000 of ordinary income Al. He has a capital gain of $50,000. So he’s curious, he’s like how’s that 10% of ordinary income, what is that going to be taxed at?

Al: You’re absolutely right. And it’s taxed at the lower brackets. So the way to think about it Joe is exactly what you said. We start with the ordinary income. Forget the capital gain income at this point, qualified income tax at 15%. That’s either going to be a sale of a stock or it could be qualified dividends for example. So you start with that $10,000. The first $10,000 for single taxpayer in round numbers is taxed at 10%. So that $10,000 will be taxed at 10%. Now the other amount of $50,000 so that’s- I’m sorry, another $40,000, to qualify as $50,000 of total income. You take out the standard deduction of about $12,000 and change for a single person. So that basically means that you’re going to be under the- or in the 12% bracket considering all of your income added together which then means all your capital gains tax-free at least for federal purposes. So yeah $10,000 at 10% roughly, so about $1000.

Joe: I would even say this. That $10,000 would probably be wiped out by the standard deduction.

Al: You know what? I’m thinking about that again. And that’s actually right. Because you want to take your ordinary income minus your ordinary deductions, and standard deduction would be considered ordinary, would wipe that out. And so therefore you’re left with-

Joe: Zero tax.

Al: – zero tax. Look at that.

Joe: So I guess let’s recap this. In a sense of, I don’t know Mike is married or single, but he’s got a question just on tax brackets. Just a simple equation of what you’d look at is that if you have a large capital gain. Just ignore that for a second because that will always sit on top of your ordinary income. So you want to look at what ordinary income sources that are coming in. So did you take an IRA distribution? Or do you have employment or wages? So you add that up and then you take off the standard deduction or if you itemize you take your itemized deductions and you subtract that off of the ordinary income. So let’s just say he only had $10,000 of ordinary income. The standard deduction would wipe out that income. So he would be zero taxed at ordinary income rates. And then if he stays in the 10% or 12% federal rates then there is no capital gains. So the capital gains rate in the lowest two brackets is zero. So if he’s married it’s up to about $80,000 of income and single it’s about $40,000 of income. So in this case Mike from A-kron would pay zero tax.

Al: That’s right. So let me put it another way too which is just for clarity. So Mike let’s pretend you had an extra $50,000 of capital gain income or qualified income. So now you’re gonna be over the 12%. So the amount of capital gain or qualified income to get to the top of the 12%, that part’s tax-free. Any amount above that would be taxed at the 15% rate. Because Joe I get that question sometimes it’s like well wait a minute I’m in the 12% bracket, but I got a property with $1,000,000 gain. So are you telling me I can sell that property and pay no tax? And the answer is No. It’s only up to the top of the 12%. All other gain will be taxed at the capital gain rates.

Tax Planning and Roth Conversions: Itemized Deductions, Dividends, and Long Term Capital Gains (David, NYC)

Joe: We’ve got David. He writes in from NYC. “Greetings from NYC where I listen to the podcast every week while walking around Central Park enjoying the info and the humor. Since I’m wearing a face mask people can’t see me laughing. Probably a good thing.” Huh. People enjoy watching other people laugh.

Al: I think it’s okay to laugh. Of course, I suppose if someone says, what’re ya laughing about? Oh, this financial show. It’s too hard to explain.

Joe: “Back in episode 266 you had a really helpful discussion about tax brackets and my question today relates to that topic and tax planning plus the ever-popular Roth conversion. Sorry. Here goes, I hope I’m providing all the details you need.” Okay, let’s see what David’s got cooking here. “I’m married; file a joint return. I’m retired; age 68 and drawing Social Security and my wife is still employed. Let’s just say hypothetically our AGI is $201,000-”  Hypothetically.

Al: Hypoth- why do you say exactly $201,000?

Joe: $201,474.

Al: But you know- give or take. Even round it down to $200,000. $201,000. So it was a rounding error.

Joe: “- taxable wages and Social Security; some fully taxable Roth conversions; short-term and long-term gains and dividends; itemized deductions from real estate; tax and contributions to a donor-advised fund are $30,000. So on the face of it, it appears that we’re basically hit the top of the 22% tax bracket which is $171,000. And if I wanted to do any additional Roth conversions they’d be taxed at the 24% rate. But if $30,000 of the $201,000 is from dividends and long term capital gains being taxed at only 15%, should I be thinking that I really could do a $30,000 conversion- an additional $30,000 to max out that 22% bracket?” So let’s stop there Al because this is a really good question. So there’s ordinary income tax. So certain income sources are taxed at ordinary income and certain other income is taxed at cap gains or dividend rate.

Al: That’s right. And so let’s start with his income. I’m going to round it at $200,000. And he’s got $30,000 of itemized deductions so his taxable income is $170,000 which is the top of the 22% bracket. So he’s thinking maybe I shouldn’t do a Roth conversion because then I’ll have to pay 24% tax. But then he thought wait a minute, about $30,000 of my income is capital gains and qualified dividends which gets taxed at 15% regardless of my income level until he gets over about $470,000, something like that. It’s a great question. And the answer David is absolutely yes. You are absolutely correct. It’s a little known trick I guess, if you want to call it that, that when you are in- pushed up into the next bracket and you have a certain amount of capital gains you can actually go into the next bracket because the old-

Joe: They sit on top.

Al: They sit on top. So the overage would be tax the capital gains rate. So in this example, David could do a $30,000 Roth conversion and still stay in the 22% bracket even though his taxable income is $200,000. Because of the $200,000, $30,000 will be taxed at the capital gains rate. And then the $170,000 is taxed at ordinary income rate. But I should mention that works for every single bracket except between the 12% and 22% bracket. And let me explain why. Because when you are in the 12% bracket your capital gains are tax free. And so if you go above, it’s roughly $80,000 dollars for a married couple, if you go into the next higher bracket to the 22% bracket I think well this makes sense because they get capital gains. Now you’ve taken your capital gain that was taxed at 0%. Now it’s taxed at 15%. And oh by the way, you’ve got to pay tax on the Roth conversion which will probably be the 12% bracket. So now you’re paying a 27% tax in that example. Hard to explain on the radio but if you think about it when you’re going from the 12% bracket to the 22% all of a sudden those capital gains which were tax-free become taxable. It’s not a good deal at all. But when you’re in other brackets, it’s a fantastic deal.

Joe: Because if you look at it they’re sitting on top. And so let’s say if David’s taxable income and let’s just assume the top of the bracket- we’re going to round here David- is $80,000. And if his taxable income was $70,000. And it was like but $10,000 of that was capital gains. Well that $10,000 capital gains would have been tax free because he stayed in that 12% tax bracket.

Al: That’s right.

Joe: But if he did a $20,000 Roth conversion and got his taxable income up to $80,000. Well now that tax- or that cap gains sits on top of the ordinary income. Now that’s in the 22% tax bracket. It’s taxed at 15% plus state plus whatever.

Al: Great example Joe. So that $10,000- the $20,000 Roth conversion, it gets taxed at 12% because that’s the bracket that you’re in. But $10,000 of the capital gains, now instead of taxed at zero are now taxed at 15%. So you got that on top of the other.

Joe: So in his example, it worked out for him. He’s like I don’t want to get the 24% tax bracket but $30,000 of this is capital gains. Well if I do another $30,000 Roth conversion. Well, guess what? That filled up that 22% tax bracket. The remaining $30,000 sits on top of your ordinary income. That’s not going to be taxed at 24%. That’s going to be taxed at 15%. So in David’s example, it works out pretty good. But if you’re in that lower tax bracket you’re filling up those lower brackets which would be a capital gain tax-free.

Al: Yes. Right. So I’m going to say, David, congrats. You’re a little smarter than I am because I learned this by accident. I didn’t think about it like you. I learned it by accident roughly-

Joe:10,000 tax projections ago.

Al: Yeah yeah. This was probably over a decade ago when I was doing more tax projections and all of a sudden we would do a bigger Roth conversion and I was thinking, gosh it’s only taxed at capital gain rate. Something’s wrong here. And I had to look into it- I go, oh of course. Because it sits on top.

Joe: Hs question goes on “Since I have to make quarterly estimated of tax payments, knowing the answer to this question would help figure out the rest of the year. Plus I really want to convert more money to my Roth since right now we are overweighted on both traditional IRAs and my wife’s 401(k). You talked about the likelihood about higher taxes down the road and I’m willing to bet on that as well. Thanks always. Keep up the great entertaining work. Details not related to the question. No car.” OK. So he just chills in the subway. Subway instead.

Al: New York City of course.

Joe: “No pets. Have I left anything out?”

Al: Do you like golf?

Joe: I don’t know.

Andi: Everybody’s gonna have a long list of questions they have to answer.

Al: We can always-

Joe: What kind of adult beverage do you prefer?

Al: What’s your wife’s name?

Andi: Getting a little personal.

Joe: Cool David. So hopefully that helps out. There’s a couple of nuggets to chew on there.

Al: Let me just add Joe that estimated payments- if you are doing a Roth conversion your income is higher. You may have to make estimated payments and that’s where you look to last year’s tax versus this year’s tax. It’s too complicated to explain right now, but just be aware. Look into it. You may need to make estimated payments.

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Taxes on Dividends Collected Vs. Dividends Reinvested (Smitty, Roseburg, OR)

Joe: We got Smitty from Roseburg, Oregon. Smitty.

Al: Gotta love that name.

Joe: I love Smitty. “Hello Andi, Joe and Big Al. I listened to your podcast where you guys we’re talking about dividends and it got me curious about two tax scenarios.” All right Al, let’s see if you’re up for the task.

Al: Ok.

Joe: We got “Scenario 1) I own $100 stock, it pays a $10 dividend, which I collect. Scenario 2) I own $100 stock, it pays a $10 dollar dividend, which I do not collect. It is automatically reinvested. Then one day later I sell $10 of it. Would the tax scenario of 1 and 2 be the same? If not, please explain. Great show by the way.”

Al: The answer is no.

Joe: So I guess let’s kind of dive in. You’ve got $100 stock, it pays- let’s just say everything else remains equal. Because for dividend-paying stocks, people just lose their mind. If the stock pays $10 folks, now pay attention here, the $100 stock price goes to $90 per share.

Al: True.

Joe: You get the $10 in hand. The stock price is now worth $90. $10 is a dividend, You’re taxed on $10.

Al: By the way $10 would be a pretty good dividend on a $100- be a 10%. I don’t think I’ve seen that before.

Joe: That’s a $10-bagger.

Al: Pretty good. But let me explain. So whether you collect the dividend or reinvest it, makes no difference on the taxes. You still have to pay tax on the dividend. So that’s number one. So, so far we’re the same. But here’s where this gets skewed is now the next day you sell $10 of stock. So now you’ve sold some stock which now you’ve got to look at your total basis on that $10. Now you’re gonna have gain on sale on that $10. So now you’ve actually made your tax situation worse in that particular case.

Joe: Yes. So I think he’s trying to think of the example that we gave is that- if he said I had a dividend-paying stock that is paying me a $10 dividend versus a non-dividend paying stocks, then I’m creating my own dividend. But if he’s getting the dividend and then he’s then selling it the next day after ex-dividend date, it’s not very tax effective.

Al: No, he’s basically paid a couple of taxes. Now what we’ve tried to say was if you have a stock that doesn’t pay dividends or very low dividends, anytime you want to get access to the capital you just sell a little bit and create your own what we call a synthetic dividend, which is taxed at long term capital gain rates as long as you’ve held it for at least a year.

Joe: Right. And if anyone out there- if you hear the little coffee shops and things like that is that ‘oh I don’t like that, doesn’t pay dividends. I like cash flow’. They don’t really know what the hell they’re talking about.

Al: True.

Joe: I was listening to a podcast, Ricky Barnes. You know that name?

Al: Golfer?

Joe: Yeah. He was kind of a big deal back in the day.

Al: Got it.

Joe: And then he kind of laid an egg.

Al: Yeah. You’re right.

Joe: Total. Total egg.

Al: He used to wear that painter’s cap.

Joe: Yes, you are right. The guy has never won but he wore a painter’s cap and made him famous. No, I’m kidding. It was a good interview. But he’s talking ‘hey, if you were never a professional golfer, what’s the next step?’ And he’s like ‘oh I really like investments’. And then they’re like ‘oh what stocks?’ ‘Well I don’t like that one, it doesn’t pay a dividend. I like cash flow’ and I was like- ahh, idiot. I digress.

Al: He needs more seasoning in the profession.

Joe: Because we get in this kind of debate all the time. It’s like well no, dividend-paying stocks or this because it pays a dividend and blah blah blah-

Al: It gets your cake and eat it too.

Joe: Yeah. Exactly.

Al: What’s wrong with that? I get cash flow plus it appreciates. Why wouldn’t I want that? Because the stock goes down by the amount of the dividend. Not me. Every time there’s a dividend, stock goes up. It’s like well that’s because the market went up that day. You’ve been lucky so far. No, you’re wrong. Am I paraphrasing this right?

Joe: My dividends are different than anyone else’s.

Al: Joe, you do not know what you’re talking about.

Joe: You are crazy.

Al: How many times has this come up in class, that dialogue?

Joe: Millions. Millions. And then finally you just gotta agree with them. You’re right. The dividends that you have-

Al: Let’s agree to disagree. Let’s move on.

Joe: It’s like the movie ‘My Cousin Vinny’. You know the grits on your griddle cook faster than- known to man. Whatever. So yeah Smitty, you gotta be careful. You’re selling the dividend after the ex-dividend date. You’re gonna- you reinvested the dividend. It’s already distributed but you just reinvested it. So you bought more shares, with the dividend that you received.

Al: And now you’re selling shares which would cause potentially a gain on sale.

Joe: Correct. Because it depends on whatever the basis is. But the dividend that you will reinvest increases your basis by the amount of the dividend.

Al: It does. And I think that the key point here is whether you receive the dividend or not, you still get taxed on it in the same manner.

Joe: That’s why we feel that dividend- we love dividend-paying stocks too by the way people. We love them.

Al: We love all stocks.

Joe: We love all stocks. We just don’t discriminate. We don’t just want a basket of dividend-paying stocks, we want them all.

Dividends and Long Term Capital Gains – Part 3 (Smitty, Roseburg, OR)

Joe: Smitty’s back from Roseburg Oregon. “Hello Andi, Joe, Big Al. A few weeks ago you guys answered a long-term capital gains tax question for me. Thanks. Have a couple more long-term capital gains tax questions for you guys. Is an automatic dividend pay-out tax the same as manually withdrawing out the same amount on any random day that is not near the dividend pay-out day?” So Smitty is still hung up on this Big Al.

Al: Yeah I know. Let’s try to go through it again.

Joe: This is the same question, Smitty. It’s just worded differently.

Al: It’s carefully worded differently.

Andi: Maybe that’s an indication that you guys didn’t answer the question well enough for Smitty to understand.

Al: Apparently that’s the truth. ‘You answered my question, thank you. But let me ask it again, because-‘

Joe: ‘You guys are the best. Thank you so much for answering my question. I’m still confused as hell.

Al: Do you wanna take a stab at it?

Joe:  Okay. Well Smitty, let’s say if you get a dividend on a stock that has an ex-dividend date that gives- you have a $10 stock that gives you $1. The company’s issuing the dividend, you get $1, you reinvest it, you pay the tax on $1. What Al and I were talking about is that we create what is called a synthetic dividend. So let’s say that the stock price is worth $10 a share. You sell it. You sell $1 a share and then you could either spend it or reinvest it. If a stock is at $10 a share and offers a $1 dividend, the stock price will go to $9 a share. If you reinvest it, now you’ve got the other $1. Now it’s- you’re whole, but you have to pay tax on the dividend. So no matter when you’re taking a distribution, if it’s the same exact amount of the dividend, you will be taxed on what is distributed from the stock. If the company distributed the dividend or if you sell the stock with a synthetic dividend, you’re still going to be taxed.

Al: The only difference though, if it’s a company dividend, you’re taxed on the whole dividend. If you sell some shares of stock then it’s a capital gain and some of that’s return of basis. So you’re not going to be taxed on the whole thing. So it’s actually- it’s more tax-favored; just create your own dividend in essence by selling a little bit yourself. You buy that?

Joe: Yeah, I buy that for sure. Love that return of basis. That was pretty good Al.

Al: Yeah. That’s an accountant.

Joe: Also, “Let’s say that I’m at the very top of the 22% tax bracket, then withdrew $300,000 of long-term capital gains from my taxable account. Would this push me into the 35% tax bracket? Great show as always. Smitty.” Oh, AKA- he’s our RP writer- 6 stars. I love Smitty. Al, stop yawning, answer the question.

Al: OK. $300,000 capital gains. No, you still are in the 22% bracket. But the capital gains, they sit on top of it. So now you’re gonna be subject to probably the 3.8% Medicare surtax to the extent your adjusted gross income is over $250,000. And if your taxable income gets over, a married couple, about $475,000ish, then it’s going to be taxed at 20%. So it doesn’t change the ordinary income but it could be a higher capital gains tax.

Joe: Sits on top Smitty. So if you create a dividend or if the company creates a dividend, you’re still going to be taxed. Long-term capital gain sits on top of ordinary income. So that’s the lesson once again.

Capital Gains “Sit On Top” of Income? What About When Doing Roth Conversions? (Stever, Coronado, CA)

Joe: Al, we got an email in from Stever.

Al: Stever. You know when you hang around surfers- I know a few surfers in San Diego. They like to kind of call each other names like Stever. Or, let’s see-

Joe: Well he lives in Coronado.

Al: Yeah yeah yeah. That’s what I’m thinking. There’s- it’s not the best surfing in San Diego, but there is surfing in Coronado.

Joe: Stever. I don’t know, if I was named Steve, and someone called me Stever, I might slap him in the face.

Andi: It might be a typo, you guys. He might have accidentally put that ‘r’ that on the end.

Joe: I don’t know.

Al: I think I’ve seen a Stever.

Joe: I’ve been to Coronado. I guarantee it, I think I met Stever.

Al: He was on his surfboard right?

Joe: Yeah. Well all right. So here what he writes. “Let’s just say I drive a Mercedes because I know you care.” I guarantee you-

Al: He’s just saying- it’s not a Mercedes.

Joe: Guaranteed. He wrote Stever. And he “wants to do a 2020 Roth conversion using pre-tax IRA account containing a few hunsky-” Look at the vocabulary in Stever.

Al: That’s why I think he’s a surfer. He’s talking surfer lingo.

Joe: A few hunsky.

Al: Hunsky.

Joe: Alrighty. Hunsky, to me… I’m not even going to go there.  “- while planning to leave a significant amount in the same IRA. For 2020, I will have wages of $300,000 plus long term capital gains of around $500,000 for a payout when the company I worked for sold. I believe I’ve heard you say that capital gains rest on top of income but I’m not quite sure what that means. Does that mean capital gains don’t count toward my income moving into a higher tax bracket? My wages are usually around $300,000. In 2019 my marginal tax bracket was 24% but I had very little capital gains. I’m married, filing jointly, and over 60 and starting to think about RMDs and the related tax rates. Although I’m a bit concerned I might end up in the 32% tax bracket if or when I convert portions of the IRA, I’m questioning if it might be worth the tax hit even at the higher tax bracket given the historical stock market average gains around 10%. I’ve never heard you recommend converting at the 32% but I’m pretty convinced tax rates are going up, when I take an RMD they will be significantly higher than the 24% tax bracket I’m in today. I’m interested in your opinions. If you think it might make sense to convert to the 32% rate since the minimum time I expect to have a Roth is going to be over 5 years where I start chipping away at it. Thanks for your thoughts and a very entertaining program.” Stever. Couple hunsky in the old IRA. Cruising around in a Mercedes.

Al: A few hunsky. You think it’s probably like a… I’m gonna guess about a 1998 Mercedes, maybe a diesel.

Joe: Definitely diesel. I like his question here. So let’s first start- explain again Alan- so his is wages are $300,000. He’s got a big capital gain this year of $500,000. So he’s like the capital gains sits on top. Does that mean-? What does that mean?

Al: What does that mean? Right? Let’s start there. So Stever, your $300,000 of income. And if you just do the standard deduction for a married couple, it’s about $25,000, so your taxable income is about $275,000. We just mentioned the top of the 24% bracket is about $325,000. So actually I’m ignoring the capital gains to start Joe. I’m just going to do the ordinary income. So Stever could do a $50,000 Roth conversion roughly and still stay in the 24% bracket. So you figure out the ordinary income rate first before you look at capital gains. That’s why I say they sit on top of. So you go through that calculation, you’ve got about $50,000 of room Stever in the 24% bracket. Crack myself up. Anyway, now- capital gains. Capital gains roughly, once you get over about $500,000 of income, they go from 15% tax rate to 20%. So this Roth conversion, if you did it, the $50,000 would be taxed at 24%, but it would also push you $50,000 more of capital gains into the higher 20% rate. So that’s a 5% delta. So you’d have another 5% tax on the capital gains. So really it’s not 24%, it’s 29% tax rate. When you think of it that way. And then of course you get state tax on top of that, which in California given these amounts probably is 10.3% or even- yeah probably 10.3%. So another 10%, so you’re close to 40%. That’s getting a little expensive, I think, to do a Roth conversion. I might wait until you don’t have the big capital gains, so you don’t have that extra tax, that extra capital gains tax. But that’s how you calculate this. You calculate ordinary income tax first and then you see what the capital gains taxes are. Because you have more ordinary income tax, it means your capital gains got pushed into a higher bracket for the capital gains side.

Joe: But I think the question there too is, how much money does he have in retirement accounts that he wants to convert? We really don’t know what that is. Because if he’s got millions and he’s got a fixed income, let’s say a large pension, he’s chilling in Coronado, so the bracket might be a lot higher in the future for him depending on what is other fixed income sources are. And how much money that he has, and what the RMDs are going to be, and so on. But I agree with you, just with the information we have, 40% seems a little bit rich. But we have recommended converting in the 32% bracket. We’ve recommended converting in the 37% bracket, just because of the amount of money that someone has and where we projected their tax is going to be in the future.

Al: And that’s typically based upon someone that feels tax rates are going up, which we tend to believe as well.

Confirming How Capital Gains Are Stacked on Top of Ordinary Income

Joe: Let’s go to Susan. She writes in. “Hey Joe, Al, and Andi. I’m writing from the suburbs or maybe exurbs outside of Atlanta, Georgia-” HotLanta. So Susan, she drives a 2005 Acura MDX. That’s kind of sexy “- and I have an 8-year-old lab hound mix named Rex. She’s got a question on capital gains that are stacked on top of ordinary income.

Al: That’s the exact term I used, stacked on top.

Joe: So we had a previous episode you mentioned capital gains are stacked on top and don’t change the tax bracket. “Can you confirm that my understanding is correct? For the first time in several years, I sold some stock in my non-qualified account. The stock was from a former employer so I could buy a discount for my 401(k) match was also in company stock. I want to reduce my exposure to the single holding. This sale was a gain but should have zero tax consequences because she’s in the 12% head of household tax bracket. I use my annual expected self-employment income, my expected dividends, and this gain amount, to estimate adjusted gross income. Then converted funds to my Roth based on the amount available within my tax bracket, using the calculated AGI. Does the stacked on top that Al mentioned mean that I can convert additional funds from my Roth equal to the gain amount while still staying in that 12% bracket?”

Al: So let’s kind of break this down a little bit. So when you’re in the 12% bracket and so Susan, I don’t know if you’re married or single, but let’s just say-

Joe: Head of household. Head of household.

Al: – head of household. OK. Oh boy. Now I gotta look up what the- what that table is. The top of the 12% bracket for head of household is $54,000,  $54,000 of income. All right. Let’s say taxable income. So Joe, you already kind of went through this. Your income minus $12,000 standard deduction, roughly. So let’s say she does that calculation, she’s at $40,000. So what did I say, $54,000? Yeah. $54,000. So there’s $14,000 of room. So now you can sell stocks with $14,000 of gain and pay no tax. If you sell stocks with $15,000 of gain, the first $14,000 is tax-free. But the extra $1000 is taxed at a 15% tax rate. That’s the way this works. So you can’t sell everything, it’s just to make sure that you stay below that $54,000. That’s how capital gains work. Now, when you do a Roth on top of that $14,000 because you think you get $14,000 of room, so the Roth pushes your taxable income to $54,000 already. So now if you do a capital gain on top of that, you will pay 15% tax on the capital gains so you don’t get to do both. And here’s what we’ve seen happen is people try to do both. They try to do a Roth conversion to the top of the 12% bracket and they try to do a capital gain to the top of the 12% bracket. You can’t double do it. You only get one 12% bracket. And when you do that, it becomes a very expensive Roth conversion. Because if you think about it this way, your Roth conversion is taxed at 12% because you’re in that bracket. Your capital gains, which would have been tax-free, got pushed up into the next bracket and now they’re taxed at 15%. So now it’s a single dollar of Roth, you’re paying 27% tax. Because of the 12% plus the 15%. And I’ve seen that happen. And in the old days, you used to be able to re-characterize in the following year before you filed your tax return to fix it. Now you can’t. You’re not allowed to re-characterize. So just be very careful in combining Roth conversions and capital gains when you’re in the 12% bracket.

Joe: Because the capital gains sits on top. It stacks on top. So if you did the conversion to the top of the 12%, which is $54,000, so now you used up that 12% bracket and then you sell- the capital gains is on top of the $54,000. So you’re going to be taxed at 15% because it sits on top of the conversion.

Al: Yep.

Joe: Hopefully that clears things up, Susan. Appreciate your questions. Very good questions, appreciate it.

TSP to Roth IRA Conversion: Long-Term Capital Gains vs. Ordinary Income?

Joe: We got Tim writes in. Tim the stalker, Andi? Is that who this is?

Andi: Yes. Yes, it is.

Joe: Got it. OK.

Andi: I’m so glad Tim’s the stalker instead of me now.

Joe: Yes. He’s out of control. This guy follows me everywhere. He’s in line at the grocery store. He’s like ”hey, I’ve got a Roth question for you.’

Al: All right.

Joe: I’m like who are you? Get away- oh Tim.  Tim, you crazy man. Tim writes in. He goes “Hi. I’m a long time listener and I have appreciated the excellent response to the questions I’ve had.” You’ve had a lot, Tim. He’s worse than Bruce. I mean these guys are just milking us, Al.

Al: They are. It just never stops.

Joe: “When listening to your recent comments on 401(k) conversions to a Roth IRA, I thought of a tax question. I transferred a portion of my government TSP to Roth IRA at a brokerage house, just enough to keep me at the top of the 24% income tax bracket. The TSP or thrift savings plan does not transfer its fund, but cashes them out and sends the cash amount to my brokerage house. Even though the TSP cash was going to a Roth IRA at the brokerage house, the transfer became regular income added to my tax year causing a significant tax burden. Since the fund and the TSP were long-term held for many years, should that income be considered long-term capital gains and taxed at the long-term capital gains rate versus ordinary income at the 24% tax bracket? Or because the TSP cashed out the amount and sent cash, does that just become regular income even though it went to my Roth IRA? I have since transferred the remaining amount of my TSP 401(k) to a new traditional IRA at the brokerage house and purchased ETF stocks and mutual funds within that traditional IRA. The brokerage house can convert the stocks ETF mutual funds to my Roth directly. If after a year, I convert the traditional IRA assets to a Roth IRA, will that be considered long-term capital gain and taxed at the lower long-term capital gains rate? Thank you.” So Tim has asked multiple questions over the years, Al. A longtime listener.

Al: Yes.

Joe: Is he really comprehending anything that we’re talking about?

Al: Well he’s- and he asked several questions here, but they’re all the same question.

Joe: So here’s- this is what scares me. He goes ‘I’m gonna convert to the top of the 24% tax bracket.’ So he’s already thinking I’m gonna be paying 24% that’s why I’m converting to the top of the 24%.

Al: Yeah I agree. So we got through the second or third sentence I thought OK. So far, so good. And then it all went south after that.

Joe: Right. And then he’s like well wait a minute, then they cashed out my TSP. So when you go from a 401(k) or TSP or type of employer-sponsored plan, as you do a rollover to get the money out, of course, they have to cash it out. They’re not going to transfer shares. If I have an IRA, let’s say at Fidelity and I have a Roth IRA at Fidelity. I can transfer shares in kind. But he converted to the top of the 24% tax bracket. Then he’s like wait a minute, shouldn’t that be long-term capital gains? Well, no. That’s the whole reason why you do the conversion is that you’re getting rid of the- you have to pay the ordinary income tax for it to forever grow tax-free. The whole basis of a lot of our shows- because of all these questions that come in, is about Roth. And we want to get rid of the tax-deferred ordinary income tax treatment of those accounts by having tax diversification by putting money into the Roth. So if you’re already saying I’m going to go- convert to the top of the 24%- then he’s shocked that he got hit with a huge tax bill. Well, I don’t understand, where else we go with that.

Al: Well let me say it another way. So we like to draw little circles of 3 different kinds of taxation. We like to call it the Tax Triangle. But one is tax-deferred; one is taxable, and one is tax-free. Tax-deferred, that’s an IRA; that’s a 401(k); it’s a 403(b); it’s a 457. Always, always, always, always, always, always, when you take money out of any of those accounts, it’s ordinary income. Ordinary income. Never, never, never capital gain. Whether it gets cashed out or you trade; you do a conversion of shares in kind, it doesn’t matter. It’s all ordinary income. That is right, Joe. That’s why we encourage people to get money out of those accounts so they can either have tax-free or capital gain in the future.

Joe: The only way it would be capital gain rate is if it was net unrealized appreciation. You could take company stock out of the 401(k) plan and move it into a brokerage account, sell that stock and pay capital gains rate, but it was in a TSP, it’s mutual funds. So he took the money out. It’s going to be taxed at ordinary income rates. The top of the 24%, you’re gonna pay 24% on those dollars, plus the state of California. I think is where you live. So yeah. But then all those dollars will grow tax-free. So hopefully, that helps Tim. Appreciate the email.

What Does “Capital Gains Ride on Top” Mean? (Jim, Santa Cruz, CA)

Joe: “Happy New Year, Andi, Al and  Joe. Jim here from Santa Cruz calling.” Is this the same Jim from Santa Cruz that calls all the time?

Andi: Yes. And he never calls. He always emails. But you always say that people call. So he’s just taken that to go.

Joe: Call.

Andi: He’s running with it.

Joe: “I’ve been listening to your show for the last year or so while running the vicious, heartless, cruel, stairs at Apatos beach.”

Al: Aptos.

Andi: I think that’s Aptos.

Joe: You never ran the stairs. When you run the stairs, you call it Apatos. It’s a pain in the ass. It’s vicious. It’s heartless.

Andi: Nice save.

Joe: Yes. “This often backfires. By the time I’m done, I’m so exhausted that I’ve forgotten everything I’ve learned. But what the heck? Here’s my question for today. Excluding my long-term capital gains, my 2020 AGI will fall just below $80,000, the top of the married 12% tax bracket. Al and Joe frequently mention the 0% rate of capital gains in the first two income tax brackets and that capital gains ‘ride on top’ of their regular earnings. But I’m unclear on exactly what ‘ride on top’ means. It would be awesome if the $41,000 of capital gains I realized last Fall are tax-free. But that seems too good to be true. Or is it? Thanks for the great show you produce each week.”

Al: It’s too good to be true. So here’s how this works, Jim, is you said your AGI is just below $80,000, so let’s say it’s $78,000 just to make up a number. So if you want to sell stocks or whatever and generate $41,000 capital gains, only $2000 is tax-free to the $80,000. Everything else above that or in this example, $39,000 would be taxed at 15%. So when we say ‘to the top’ that just means the portion of your capital gains that keep you in the 0% tax bracket- I’m sorry, the 12% bracket, get taxed at 0%. That’s how this works. By the way, we talked about in episode 303, 295, 292, 287, 272, and 266.

Joe: Well, the guy’s killing it running the stairs.

Al: But he’s forgotten that because he just runs the stairs-

Joe: He hears ‘on top’ and it’s like I knew something good happened there.

Al: Yeah, that’s right.

Selling CDs in a 401(k): Capital Gains or Ordinary Income? (Dr. James, Serra Mesa, CA)

Joe: I’m reading this- did we already…?

Andi: So Dr. James- is that the one you’re looking at?

Joe: Yep.

Andi: So he’s the one that actually gave you the back advice. He’s the real doctor. So you talked about his back advice, but then you never answered his question.

Joe: Oh, sorry, Dr. James. OK, so “50 years old drives a 9-year-old compact Lexus hybird- hybrid- ”

Al: It’s a hybird car. What are the- ? I’ve not seen a hybird, but I have seen a few hybrid.

Joe: He wrote hybird.

Al: I know. I’m aware of that.

Joe:  “- with 100,000 plus miles on, it still gets 50 miles per gallon.” Geez.

Al: That’s pretty good.

Joe: “My 401(k) has an assortment of 30 different traditional funds, index, large-cap, value growth, domestic, international, global, target date, bonds, whatever. My 401(k) also has a brokerage linked component to a much larger selection of individual stocks, bonds, ETFs, etc. Within the brokerage link, I recently sold some 3.5% 10 year CDs on the secondary market for a nice 20% gain when I purchased in January 2019. The 401(k) fixed income agent who talked me through the fairly confusing online transaction, told me on the phone, ‘There you go. Done. And since you sold them in February, 2021, they’re less than two years old-

Al: – they’re greater than-

Joe: “- they’re greater than two years old, that’s a nice cap gain.’ Is he correct?”

Al: No.

Joe: “Will these profits be treated like capital gains when I begin taking money out of the 401(k) when I retire?”

Al: Nope.

Joe: “Or will everything be- everything that I take out be subject to ordinary income tax?”

Al: Yes.

Joe: “Note: all contributions to my 401(k) have been pre-tax. Thanks, great information, educational and entertaining podcast. I read the transcripts every week and I’ll keep Joe’s back in my prayers.” Well, thanks, Dr. James.

Al: Well that’s nice.

Andi: Just your back though.

Joe: Look at the funnies on Andi.

Andi: The rest of you, not in his prayers.

Al: I suppose that is a correct interpretation or I mean, that’s how it reads. I don’t really care about you, but your back? Now I care about that.

Joe: I got foot-drop. Drop-foot.

Al: Sorry about your foot-drop.

Joe: It’s awful.

Al: All right. So any time you have any kind of gain in a 401(k), it’s not taxable at the point where you do the sale. But when you pull the money out, it’s always ordinary income. That’s the problem with 401(k)s, IRAs. It’s always ordinary income, even though it would otherwise qualify for a capital gain. So the brokerage link broker is incorrect.

Joe: Well, the brokerage link broker might have not understood that it was a 401(k).

Al: Yeah, but he says ‘the 401(k) fixed income agent-‘  It seems like he would know it was a 401(k).

Joe: He would know, right?

Al: You would think so.

Joe: Yeah. There you have it.

Al: He’s not- I wouldn’t take your tax return to him to prepare.

Joe: Probably not. I would have him buy and sell your CDs, make a 20% gain on it.

Al: Yeah, that’s pretty good.

_______

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