by Doug Parham

Capital gains and qualified dividends are taxed at a variety of rates for federal tax purposes. Currently, the common rates include 0, 15, 20, and 23.8 percent. You might be surprised to know the characteristics of taxpayers who have been able to make use of the zero percent tax rate on capital gains and qualified dividends.

Tax law tells us that the zero percent rate is applied so long as your ordinary income is being taxed in the 10 or 15 percent brackets. The amount of capital gains that will be taxed at the favorable rate of zero is limited to the amount remaining in the 10 and 15 percent tax brackets after ordinary income has been taxed. If ordinary income is taxed at rates higher than 15 percent, but less than 39.6 percent then the 15 percent rate applies to capital gains and qualified dividends.

The ordinary tax brackets are adjusted annually for inflation. For 2015 the 10 and 15 percent tax brackets applicable to ordinary income include income up to $74,900 for married filing joint taxpayers and $37,450 for single and married filing separate taxpayers. Keep in mind that this is “ordinary” taxable income and not total taxable income. To determine if the zero percent tax rate applies, qualified dividends and capital gains must be identified and subtracted from taxable income to arrive at ordinary taxable income. The amount of ordinary taxable income will then determine the tax rate applicable to qualified dividends and capital gains.

I have referred to five actual tax return situations to illustrate what happens in the calculation of taxing capital gains:

  • The first taxpayer is single, has adjusted gross income (AGI) of $119,921, taxable income of $101,701, including qualified dividends of $3,119 and capital gains of $4,888. Separating the qualified dividends and long-term capital gains from taxable income, we arrive at taxable ordinary income of $93,694 (101,701 less the sum of 3,119 and 4,888). Since this exceeds the 15 percent bracket amount of $37,450, the capital gains will be taxed at 15 percent.
  • The second taxpayer is married and files jointly with his spouse. They have AGI of $628,745, taxable income of $53,966, including qualified dividends of $136,324 and capital gains of $134,356. Separating the qualified dividends and long-term capital gains from taxable income, we arrive at taxable ordinary income of less than zero. Therefore, the first $74,900 of qualified dividends and long-term capital gains will be taxed at zero percent and the rest will be taxed at 15 percent.
  • The next taxpayer is married and files jointly with his spouse. They have AGI of $553,486, taxable income of $471,463, including qualified dividends of $129,417 and capital gains of $379,023. Separating the qualified dividends and long-term capital gains from taxable income, we arrive at taxable ordinary income of less than zero. Therefore, the first $74,900 of qualified dividends and long-term capital gains will be taxed at zero percent and the rest will be taxed at 15 percent.
  • The next taxpayer is single, has AGI of $380,719, taxable income of $325,702, including qualified dividends of $38,880 and capital gains of $193,386. Separating the qualified dividends and long-term capital gains from taxable income, we arrive at taxable ordinary income of $93,436. Since this exceeds the 15 percent bracket amount of $37,450, the capital gains will be taxed at 15 percent.
  • The final tax return I looked at was for a married couple having an AGI of $352,511 and taxable income of $94,220. Their AGI included qualified dividends of $171,116 and capital gains of $142,287. Since the qualified dividends and long-term capital gains exceeded the taxable income, $74,900 will be taxed at zero percent.

These five examples may seem very similar in fact patterns, but they point out the applicability of the zero percent tax rate for taxpayers with high levels of AGI and taxable income. They also demonstrate that similar AGI’s don’t necessarily result in similar amounts of taxable income or amounts of tax. The taxpayers in examples 2 and 5 above used charitable giving to drive their taxable income down and the total income tax that resulted was only 6 and 3 percent of AGI, respectively. Whereas, examples 3 and 4 did not use charitable giving and/or did not have significant qualified dividends and their total income tax as a percentage of AGI was 13 and 21 percent, respectively.

Many times transactions that result in capital gains are planned and contemplated. Income from qualified dividends is a more steady, regular occurrence. When you receive income from these two sources you should be particularly aware of the amounts of your other income and itemized deductions to attempt to achieve the best overall tax result.

Notice that in the determination of the tax rate to apply to capital gains and qualified dividends, itemized deductions are used to offset ordinary income. This factor is very important to determining the tax rate that will apply to capital gains and qualified dividends. If you are able to time your ordinary income and pair it with applicable amounts of itemized deductions to stay within the 15 percent tax bracket (thereby avoiding the 25 percent bracket), it is possible to take advantage of the zero percent tax bracket on some amount of capital gains and/or qualified dividends. Managing tax brackets for both ordinary income and the special capital gains and qualified dividends can have a very significant impact on your overall tax bill. Ordinary tax rates of 15 instead of 25 is very significant and having any of your capital gains and qualified dividends taxed at zero instead of 15 is huge.

If you contemplate income from capital gains and/or qualified dividends during 2015 be sure to take time to consider the other elements of your income and itemized deductions to determine if there are opportunities to find the zero percent tax bracket for any portion of those dividends or capital gains. Planning during the year, in anticipation of events or with various outcomes in mind can lead to better tax/financial results come the end of the year.