Short and long term cap gains taxed higher than expected

Question

This is my first year including the sale of RSU's (or any stocks) in my taxes. My expectation was that short term gains would be taxed at a rate similar to my normal income tax rate, and long term gains would be taxed at 10%. However, the numbers generated by online tax software are higher than expected. I used two popular sites to cross-validate, and they both generated almost identical numbers.

For short term gains, the fed tax rate appears to be close to 39%, which is higher than my income bracket's tax rate (33%). I.e., if I add a stock sale to my tax report where the short term gain was $1000, my fed amount owed goes up by $390.

For long term gains, the fed tax rate appears to be close to 26%, which is higher than the expected 10%. I.e., if I add a stock sale to my tax report where the long term gain was $1000, my fed amount owed goes up by $260.

Can anybody shed any light on this?

Answer 1

You may have run into one of the more devious issues of the tax code: "phase outs". Certain deductions (state/real estate taxes, dependents, overall deductions, AMT deduction) are are reduced or capped as your income increases.

Although intended to penalize "high" incomes, these typically hit middle incomes the hardest. For example, the AMT has three tax rates: 0%, 26% and 28%. However due to the "phase out" the incremental tax rate for people in the phase out rate is 35%. That's neither the people at the top nor the bottom.

The best way to figure out what's happening is to run both scenarios (with and without RSUs) and compare the resulting 1040s line by line and identify where the major differences are.

Answer 2

In addition to the income tax on capital gains, you may also have to pay Medicare tax on investment income. The Medicare tax has two rates, 2.9% and 3.8%. Investment income is taxed at the 3.8% rate if taxed. You say that you are in the middle of the 33% bracket. That suggests that you are above the threshold where you have to pay the Medicare tax on investment income. There is a small range where your tax rate is 33% and you don't, but that of course is toward the bottom of the range.

The 3 thresholds to note:

• $250,000 for married couples filing jointly
• $125,000 for married spouses filing separately
• $200,000 for single and head of household (with qualifying person)

Your long term capital gains rate should be 15% in the 33% tax bracket. So 18.8% with the Medicare tax.

Beyond that, you could be losing a deduction due to having too much income. Or hitting the Alternative Minimum Tax. You'd probably have to read the actual forms to find that.

Answer 3

There are phase-outs of several tax reductions that are based on AGI, so an increase in AGI can increase the tax on your other income in addition to the 36.8% or 18.8% tax on the investment income.

Some of these include the personal exemptions and itemized deductions.