I read your post “How To Intentionally Realize Capital Gains” but I did not understand what you meant when you said that taxable income fills up the brackets first. Can you explain?”

The IRS does not do a good job of helping people understand capital gains taxes. They provide a worksheet to help you calculate it, but it has so many steps that it’s nearly impossible to figure out what’s going on. We also know that capital gains tax rates correspond to certain normal income tax rates, but how they work together is obscure.

Many people think that the right method to calculate capital gains tax is to calculate your taxable income, find the tax rate on that, use that to find the corresponding capital gains tax rate, and multiply all your capital gains income by that rate. Others think that the capital gains rates only apply to capital gains income, so you would have to have more than $74,976 (using tax year 2016’s numbers) before you have to pay capital gains taxes. Both of these interpretations would be sensible and it’s easy to forgive the mistake given how the IRS and some financial commentators talk about capital gains. Unfortunately, it’s actually a little more complex.

The amount of your taxable income that is taxed according to the ordinary rules (wages, interest, and so on minus deductions and exemptions) use up the space in the lowest capital gains tax brackets. For people with low taxable incomes, this might not affect them, but for many people, this can cause some of their capital gains to be taxed more highly than they would have thought.

So for a married couple with $100,000 of taxable income, $40,000 of which is due to capital gains, it will work like this:

Using the figures for 2016, the 0% capital gains bracket ends at $74,976. This couple has $60,000 of ordinary income. That leaves only $14,976 of space in the 0% capital gains tax bracket and only that amount of capital gains will be taxed at 0%. The remaining $25,024 will be taxed at 15%. This leaves a tax bill of $3,753.60 on their capital gains.

Now let’s compare this to the two common mistakes people make regarding capital gains taxes.

For those who think capital gains taxes only consider capital gains income in their calculation, they would note that $40,000 of capital gains does not exceed the 0% capital gains tax bracket, so none of it would be taxed. These people will be unpleasantly surprised when the IRS tells them they owe close to $4,000 extra.

The others, who use total taxable income to find their capital gains tax rate, will be happier because the capital gains tax, like the income tax, is progressive. They would note that $100,000 of overall taxable income corresponds to the 15% capital gains tax bracket and tax all their gains at that rate. They would think they owe $6,000, more than $2,000 too high.

Both mistaken formulas are attractive because of their extreme simplicity. The truth is more complex than that, but not as hard to understand as the IRS worksheet would suggest.

Because the rate at which capital gains are taxed partially depends on how much ordinary income you have, it is important to remember exactly how the tax works when you are considering actions that might cause your amount of ordinary income to fluctuate. With a good financial planner, the most likely reason this will happen is from Roth conversions.

Roth conversions put money into an account where it, and its growth, will never be taxed again. This is tremendously beneficial, but it also requires taking money out of a currently non-taxable account and paying the tax on it. The amount you convert is considered to be ordinary income. Unless your financial planner is careful, this can have powerful effects on your capital gains taxes.

If they know about your Roth conversion plans, your tax situation, and manage your account trading, they can help you avoid pain at tax time. For taxpayers who have different people for financial advice, trading, and tax planning, it’s easy for all of those people to operate without knowing anything about the others’ work. This can lead to a problem where the person recommending Roth conversions converts a lot and the traders ignorantly realize a lot of capital gains as well. The Roth conversions eat up all the low capital gains tax brackets and the gains get taxed much higher than anybody would want.

Capital gains taxes aren’t too complicated, but their quirks mean that it pays to have a good comprehensive wealth manager to help you out, especially if you plan to take advantage of other wealth-building tools.

Photo from Unsplash.