For most taxpayers, the amount of federal income tax they pay depends on where they fall in the federal income tax brackets and the breakdown of their taxable income between ordinary (e.g., wages) and capital gains from the sale of assets (e.g., common stock). Taxpayers eligible for the lower federal income tax brackets (those under 25%) on their ordinary income can generally expect to be taxed at 0% on their long-term capital gains. Taxpayers in the 25% or higher federal income tax brackets can generally expect to be taxed at either 15% or 20% (again, exceptions apply) on at least a portion of their long-term capital gains.
It seems inevitable that, as federal taxable income increases, the rate we pay on at least a portion of that income also increases. The converse should and does apply. That is, as federal taxable income decreases, the rate of tax we pay on at least a portion of that income also decreases. In addition, if a taxpayer has a long-term capital gain that, after considering ordinary income, is partially taxed at the 0% rate, any additional deduction that decreases ordinary income will simultaneously decrease the tax rate on a comparable amount of long-term capital gain from 15% to 0%. This has the effect of producing a double benefit for that deduction, as shown in the following example.
Example: Jack and Julie, filing jointly for 2014, have net ordinary income of $60,000 and a long-term capital gain from the sale of stock of $40,000, for total income of $100,000. For 2014, the joint rates applicable to ordinary taxable income change from 15% to 25% at $73,800. Accordingly, $13,800 ($73,800 – $60,000) of their long-term capital gain will be taxed at 0% and the balance of $26,200 ($40,000 – $13,800) is taxable at 15%. All income, both capital and ordinary, is taxed at a rate of 15% or less.
If Jack and Julie contribute $11,000 to their deductible IRAs ($5,500 each for 2014, assuming they are both under age 50), they receive a 30% tax rate savings, even though their highest tax bracket is 15%. The $11,000 IRA deduction reduces ordinary income at the 15% rate, but also shifts $11,000 of capital gain taxation from the 15% to the 0% bracket, for another 15% savings. This produces a total tax benefit of 30% on the $11,000 reduction.
A similar impact would occur for any expenditure or deduction that reduced ordinary income (i.e., Section 179 expense, additional interest expense, etc.). Conversely, adding ordinary income at the 15% bracket would cause a 30% impact, as additional ordinary income would push a portion of the capital gains formerly at 0% upward into the 15% bracket.