Why is the effective rate on the next $1,000 of ordinary income 27% when my client is in the 12% marginal bracket?

In some cases, the effective tax rate on the next $1,000 of income may be higher than the client’s marginal tax bracket.

A common example occurs when additional ordinary income pushes long-term capital gains or qualified dividends out of the 0% capital gains bracket and into the 15% bracket.

When this happens, the additional tax caused by the capital gain rate change is included in the effective rate calculation, as illustrated in the example below:

Why This Happens

The U.S. tax system applies a stacking rule when calculating taxes on capital gains and qualified dividends:

1. Ordinary income fills the tax brackets first.

2. Long-term capital gains and qualified dividends stack on top of ordinary income.

Because of this rule, adding ordinary income can shift capital gains into a higher tax bracket.

When that occurs, the tax increase includes:

• the tax on the new ordinary income, and

• the additional tax on existing capital gains or qualified dividends that move into a higher bracket

This combined effect can produce an effective rate that is higher than the marginal ordinary income bracket.

Example

In the example below, the MFJ client has $122,800 of taxable income, of which $52,500 reflects long-term capital gains and qualified dividends. This leaves $70,300 of ordinary income, which puts them in the 12% marginal bracket :

In 2026, this is how those capital gains and qualified dividends are taxed: some is taxed at 0%, with the remainder taxed at 15%:

Step 1: Add $1,000 of ordinary income

When an additional $1,000 of ordinary income is added:

• The $1,000 is taxed at 12%

• However, the extra ordinary income pushes $1,000 of capital gains out of the 0% bracket into the 15% bracket

Step 2: Calculate the additional tax

Step 3: Calculate the effective rate

$270/$1,000 = 27%

Even though the client’s marginal ordinary income bracket is 12%, the effective rate on the next $1,000 of income is 27% because of the capital gains interaction.

Key Takeaway

The effective rate on additional income reflects the total tax impact, not just the marginal ordinary income bracket.

Effective rates may increase when additional income:

• pushes capital gains or qualified dividends into a higher bracket

• causes Social Security benefits to become taxable

• triggers phaseouts of credits or deductions

These interactions explain why the effective rate shown in Holistiplan may differ from the client’s marginal tax bracket.