Taxes and investing go hand in hand, and it's important to understand the basic federal income tax rules to help guide your investment decisions throughout the year. The accompanying pyramid provides an overview of the current tax picture.
Start with the basic graduated tax rate structure for ordinary income. The structure includes seven tax rates ranging from a low of 10% to a high of 39.6%. For the lowest rates, the brackets for joint filers are double what they are for single filers, but the joint filer brackets aren't twice as wide for the higher income tax rates. This disparity may result in a "marriage penalty" for some high-income investors. But all of the brackets are adjusted annually for inflation.
A couple of other key tax rules reduce tax benefits for high earners. As shown in the pyramid, most itemized deductions and all personal exemptions are phased out above specified modified adjusted gross income (MAGI) thresholds. The reductions stem from the Pease rule and the PEP (personal exemption phaseout) rule, respectively. Both thresholds are adjusted annually.
Another recent development, the 3.8% surtax on "net investment income" (NII), further clouds tax issues. The 3.8% surtax applies to the lesser of your NII or the amount by which your MAGI exceeds $200,000 if you're a single filer or $250,000 for joint filers. Those thresholds don't get annual inflation adjustments.
Finally, consider the main tax rules for capital gains. Short-term gains on assets you've held for a year or less are taxed under the ordinary income tax rate structure. However, long-term capital gains for assets you keep longer than a year benefit from preferential tax treatment. There are three main categories:
- The rate for gains up to the top of the lowest two ordinary income tax brackets is 0%.
- The rate for gains between the lowest two ordinary income tax brackets and the top tax bracket is 15%.
- The rate for gains in the top ordinary income tax bracket is 20%.
Generally, capital gains and capital losses offset each other, so it often pays to consider selling certain assets based on the gain or loss you would realize. With that in mind, it may be most effective to harvest long-term losses that would offset short-term gains that would otherwise be taxed at your full rate for ordinary income. The least effective strategy is to use short-term losses to offset long-term gains.