Taxable income, Capital Gains and Qualified Dividends

[vexed]

I am confused regarding the calculation of taxable income and the impact the resulting tax bracket has on what I pay in federal income tax on my Qualified Dividends (QDs) and Long Term Capital Gains (LTCGs).

In reviewing the IRS-1040 I note that QDs are placed in a column to the left of the column used to calculate Taxable Income (lines 1-43). The next time the QDs influence the numbers on the 1040 are on line 44 (which is the line after the line Taxable Income is determined) and then it is only the tax that the QDs generated, along with the other taxes incurred, not the actual QDs. Am I correct that QDs are NOT counted as Taxable Income for the purpose of defining taxable income and its associated tax brackets?

I am thinking the same line of logic also excludes LTCGs from showing up in the Taxable Income column. Unfortunately, attempting to backtrack the calculations on the Schedule D Worksheet is beyond me. Are LTCGs counted as Taxable Income (line 43)? If yes, how do I capture the 0% tax applicable to LTCGs if I am in the 15% tax bracket (in 2013 it’s 15% on LTCGs for the 25% tax bracket)?

Thanks

[kaneohe]

QDIV and LTCG are included in AGI (QDIV as part of total dividends). Taxable Income = AGI less adjustments/deductions/exemptions.
QDIV and LTCG (for simplicity here, assume only have LT gains) are then subtracted from taxable income. The ordinary income tax
is calculated separately on that difference (Taxable Inc less QDIV/LTCG) and then the tax on QDIV/LTCG is calculated separately at 0 or 15%
and then added to the tax on ordinary income. If you follow line by line on the QDIV/CG wksht , you might be able to isolate these various steps.

The QDIV/LTCG do not affect (to the 1st order) the taxation of the ordinary income. However, the ordinary income affects the taxation of the
QDIV/LTCG since the ordinary income determines whether the QDIV/LTCG sits in the 15 or 25% (or higher) brackets. You can recognize these lines
in the QDIV/CG wksht since it will tell you to multiply by 0% or 15%.

see the stacked bar chart by tfb here for an intuitive way to understand/remember this concept:
http://www.bogleheads.org/forum/viewtopic.php?f=10&t=86849

edited to put in correct link

[vexed]

see the stacked bar chart by tfb here for an intuitive way to understand/remember this concept:
http://www.investopedia.com/articles/tax/08/file-seperately.asp#axzz2KDxRhnt8[/quote]

Thanks. I need to think about your response for awhile. I am still puzzled as to why Ord Dividends (Line 9a 1040) are used to calculate Taxable Income and QDIVs are clearly excluded from this calculation (Line 9b) yet you say they are both used to calculate Taxable Income. But in the meantime, I cannot locate the bar chart you reference when I open this link. Maybe that would clarify things for me. Can you focus this target a little bit better?

[kaneohe]

apologies for that bad link......have no idea how that happened:

http://www.bogleheads.org/forum/viewtopic.php?f=10&t=86849

tfb chart is dated 12/11/11

I don't like the term IRS uses "ordinary dividends" since it includes QDIV. I would prefer "total" (tho there are issues w/ that too) so that
"total" would include "ordinaryR" and "qualified" components. AGI includes the IRS "ordinary" which includes both my "ordinaryR" and "qualified"
components..................then when you are doing the wksht, you subtract out the "qualified" component , and calculate the tax on your ordinary income which includes my "ordinary" component of the "total" dividend but not the "qualified" part.

You don't include both the "ordinary" AND "qualified" dividends in AGI since that would be double counting the qualified part.
fyi.....the R in ordinaryR is for Real.....what I call the real ordinary dividend. Enough confusion for now.

You may be thinking that ordinary dividends and qualified dividends are independent components..........they are not since qualified dividends are included in
ordinary dividends .

perhaps some numbers might help: in K $

wages 70
ordinary div 30
(QDIV 20)
AGI 100 (20 QDIV included in the 30 ord div)
deduction 10 just for example
exemption 8 just for example
taxable inc 82

less QDIV 20
net 62
calculate tax1 on net = use ordinary table/rates
calculate tax 2 on QDIV= use 0% on 9K (roughly) and 15% on 11K since QDIV straddles the 15/25% brackets for MFJ
total tax = tax1 + tax2

[vexed]

Got it this time... hmmmmm, another misconception dispelled. Until I looked at those bar charts I was under the impression that once my taxable income exceeded the 15% tax bracket threshold ALL of my QDIVs and LTCGs were taxed at the 15% rate even that portion that were under the 25% tax bracket floor. If I am reading the charts correctly the marginal rates apply to QDIVs and LTCGs in the same manner they apply to ordinary income and only that portion of my QDIVs and LTCGs that are above the 15% tax bracket ceiling (or the 25% tax bracket floor) get taxed at the higher rate.

If I got it right then you've help me immensely. Thanks.

[livesoft]

Have you tried to plug some scenarios into tax software? Taxcaster is an excellent "What if?" tool. Find it online.

[kaneohe]

The other common misconception is that if your ordinary income is in the 15% bracket, adding any amount of QDIV/LTCG is taxed at 0%.
........but I think you've got it and having fallen into the hole and then climbed out, I doubt you will ever forget it. The stacked bars help immensely, I think.

[kaneohe]

Have you tried to plug some scenarios into tax software? Taxcaster is an excellent "What if?" tool. Find it online.

Agreed and it is always good to doublecheck assumptions w/ some sort of tool.........but I think, getting the intuitive concept correct is probably even more important because even when your computer breaks down or you're on a desert island, you still have it........

[vexed]

Have you tried to plug some scenarios into tax software? Taxcaster is an excellent "What if?" tool. Find it online.

Thanks for this suggestion. I just pulled it up and I will do some forecasting when I pull all my numbers together.

[Calm Man]

OP, your post and the excellent responses beg the question: if the QDI is backed out when taxes are calculated, why include them in AGI at all? The reason had to do with items dependent on taxable income like social security taxation. But beginning this year, it becomes huge. AGI (which includes QDI) will determine the new health care tax cutoffs, phase out of deductions, phase out of exemptions and likely some other things of which I am not yet aware. Once you are over 200K if single or 250K if married, it will make a big deal from what I can tell.

[kaneohe]

OP, your post and the excellent responses beg the question: if the QDI is backed out when taxes are calculated, why include them in AGI at all? The reason had to do with items dependent on taxable income like social security taxation. But beginning this year, it becomes huge. AGI (which includes QDI) will determine the new health care tax cutoffs, phase out of deductions, phase out of exemptions and likely some other things of which I am not yet aware. Once you are over 200K if single or 250K if married, it will make a big deal from what I can tell.

The QDI isn't exactly backed out for the tax calculation.......it's backed out for the tax calculation of the ordinary income component but QDI is used for the calculation of the tax on QDI in the 15% and 25% brackets (at 0 and 15%). If you happen to be in the 15% bracket where QDI is taxed at 0%, it's as if you backed it out but if you are in the 25% bracket , there is an additional component to be added in. As you mentioned QDI can affect SS taxation. In fact, QDI can affect QDI taxation also.

[cherijoh]

It actually helps to fill out the worksheet to calculate QDiv and LT Capital Gains. It seems like gibberish if you look at the worksheet in it's entirety, but is actually fairly simple to do if you follow it one line at a time. If you are comfortable with Excel formulas, it is pretty simple to recreate as an Excel-based worksheet to test out "what if" scenarios. I did this when trying to figure out how much of a ROTH IRA conversion to do since it would influence the tax rate on my capital gains/QDiv.

C

[Kevin M]

Just use the Qualified Dividends and Capital Gain Tax Worksheet in the instructions for Form 1040, and it should be clear. TurboTax fills this out for you based on numbers you enter elsewhere. I use forms mode (desktop version) to open up the worksheet and review it, to see what's going on.

Kevin

[scrabbler1]

It actually helps to fill out the worksheet to calculate QDiv and LT Capital Gains. It seems like gibberish if you look at the worksheet in it's entirety, but is actually fairly simple to do if you follow it one line at a time. If you are comfortable with Excel formulas, it is pretty simple to recreate as an Excel-based worksheet to test out "what if" scenarios. I did this when trying to figure out how much of a ROTH IRA conversion to do since it would influence the tax rate on my capital gains/QDiv.

C

I have the tax booklet's worksheet in a spreadsheet form and it is very handy for what-if scenarios. One thing I saw when I did this is a few years ago I had some unexpected QD or LTCG income at the end of the year but even though it was taxed at 0% my federal taxes still rose a little - it was because I had medical expense deductions and the added income raised the 7.5% cutoff and lowered the deduction, raising slightly my overall taxable income.

I also wanted to measure the total added taxes when I liquidated my company stock after I left the company in 2008. I used NUA so it added a huge blob of LTCG to this worksheet so I was able to see the added amount there and elsewhere in my spreadsheet (i.e. AMT kicked in). Spreadsheets are great if you know how to use them!

[grabiner]

It actually helps to fill out the worksheet to calculate QDiv and LT Capital Gains. It seems like gibberish if you look at the worksheet in it's entirety, but is actually fairly simple to do if you follow it one line at a time. If you are comfortable with Excel formulas, it is pretty simple to recreate as an Excel-based worksheet to test out "what if" scenarios. I did this when trying to figure out how much of a ROTH IRA conversion to do since it would influence the tax rate on my capital gains/QDiv.

The IRS worksheets make it possible to get the right numbers, but it is not easy to follow the process, because the worksheets have to deal with all the obscure cases, and the intermediate calculations are often hard to understand. Here's a simple explanation which applies for most taxpayers.

Take your taxable ordinary income, and pay tax on that amount at the appropriate rate.
If you have not used up the 15% bracket, any LT gains and QDI which would take your taxable income to the top of that bracket are taxed at 0%.
If you have not used up the 25%, 28%, and 33%, and 35% brackets, any LT gains and QDI which take your taxable income up to the top of the 35% bracket are taxed at 15%.
Any additional capital gains (with taxable income above the bottom of the 39.6% bracket) are taxed at 20%.

This only applies to the income tax rate itself. LT gains and QDI are counted as ordinary income for all other purposes, such as phase-outs of tax credits. And LT gains and QDI are counted the same as other investment income for the 3.8% Affordable Care Act surcharge.

[kaneohe]

The IRS worksheets make it possible to get the right numbers, but it is not easy to follow the process, because the worksheets have to deal with all the obscure cases, and the intermediate calculations are often hard to understand. Here's a simple explanation which applies for most taxpayers.

I've only run across the common situation personally. Was just curious about what kind of obscure cases exist......don't have a very good imagination, I guess.

[grabiner]

The IRS worksheets make it possible to get the right numbers, but it is not easy to follow the process, because the worksheets have to deal with all the obscure cases, and the intermediate calculations are often hard to understand. Here's a simple explanation which applies for most taxpayers.

I've only run across the common situation personally. Was just curious about what kind of obscure cases exist......don't have a very good imagination, I guess.

The Qualified Dividends and Capital Gains Tax worksheet isn't that bad, because most of the special cases (collectibles, unrecaptured Section 1250 gain on depreciated real property) require you to file the Schedule D Tax Worksheet instead. The only special cases on this worksheet are Form 4952 (investment interest, which you cannot deduct against tax-favored investment income) and Form 2555 (income earned abroad).

The example I remember is the Social Security taxation worksheet; when preparing the wiki page, I had to work through the algebra for every line on the worksheet, then work out a simpler formula which ignores all the obscure situations.

[kaneohe]

grabiner, thanks. Guess I don't have to stress my limited storage w/ this one then.

[vexed]

Take your taxable ordinary income, and pay tax on that amount at the appropriate rate.
If you have not used up the 15% bracket, any LT gains and QDI which would take your taxable income to the top of that bracket are taxed at 0%.
If you have not used up the 25%, 28%, and 33%, and 35% brackets, any LT gains and QDI which take your taxable income up to the top of the 35% bracket are taxed at 15%.
Any additional capital gains (with taxable income above the bottom of the 39.6% bracket) are taxed at 20%.

Actually, that is where I ended up after this very useful discussion. I put together a spreadsheet that separates my estimated 2013 QDs, LTCG and Return of Capital (which is not income) on the many mutual funds and stocks I own and then apply the appropriate tax rates to my ordinary income and then the appropriate tax rates to these other categories of income. I will now adjust my federal and state income tax deductions based on this estimate. Hopefully, I will end 2013 with my tax estimate closely approximating the amount I actually owe in taxes, which was the objective of my post.

Thanks to all for the input. It was a good discussion.