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Assume my taxable income is within the 25% bracket, and my mutual funds have capital gains that year. Additionally, my being in the 25% bracket occurs before the capital gains are accounted for. It is my understanding that I would have to pay 15% taxes on those gains; whereas, if I were in the 15% bracket, I would pay no taxes on those gains.

Is it correct that the border between the 15% and 25% bracket triggers such a discontinuous change? By comparison, the ordinary income tax bracket rates are at least continuous, despite not being smooth.

If so, could I contribute more towards a traditional IRA and traditional 401(k) to return to the 15% bracket and pay no capital gains taxes, provided the contribution limits are not exceeded?

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If your capital gains income takes you into the next tax bracket (say, from 15% to 25%) then only the portion of capital gains that is above the tax bracket threshold will be taxed at the higher capital gains rate.

Capital gains tax is continuous in the same sense that ordinary income tax is continuous.

  • What if the bracket was reached without the gains? – BaronFiner Jul 24 '17 at 1:28
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    Then all the gains are taxed at the higher rate. The gain computation is determined after regular income. Instructions to schedule d (and associated worksheets) should make it clear if you have the time to go through them. – farnsy Jul 24 '17 at 1:39
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    It's discontinuous in the same sense as income tax is discontinuous. Yes. Except you described this as continuous earlier. – farnsy Jul 24 '17 at 1:44
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    You are missing something indeed. Please re-read my post or play with the tax worksheets. The capital gains tax is slope discontinuous only. – farnsy Jul 24 '17 at 1:54
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    @BaronFiner: See this question. If for instance your ordinary income puts you $100 below the 25% bracket limit, and you have $100 of long-terms gains, you will pay no tax on that $100. If you have $101 of gains, you will pay 15% only on the $1 that "overlaps" into the higher bracket. If you have $102 you will pay 15% of $2, etc. This is the same way regular income brackets work. – BrenBarn Jul 25 '17 at 6:58
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The gains can push you into a higher bracket. It's not like you can earn $15k/yr and bacause you are in the 10% bracket, have $100k in long term gains that are taxed at a zero rate.

There are online tax programs that can help you understand this. You can enter numbers for your scenario and see the results.

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