Understanding how long-term capital gains/qualified dividends are taxed and how that intertwines with ordinary income is critical in analyzing the results in Scenario Analysis
As a rule of thumb, financial advisors are taught to assume that a client's marginal bracket is going to be the rate of tax applied to the next dollar of income. But that's only partially true: the next dollar of ordinary income will be taxed at the client's marginal bracket, but the total tax impact of that next dollar could depend on a variety of things, including the phasing in or out of deductions, credits, or other taxes.
One common situation in Scenario Analysis will be when clients are in the 12% marginal bracket, but the effective tax on the next $1,000 of ordinary income is listed as being 27%. Understandably, users question what's happening in situations like this: if a client is in the 12% bracket, how can they be paying 27% on that next $1,000 of ordinary income?
The key here is recognizing that the clients in this situation have qualified dividends and long-term capital gains. And the taxation on qualified dividends and long-term capital gains is based on taxable income: below a certain threshold of taxable income (which changes each year), any portion of taxable income that consists of long-term capital gains and qualified dividends is taxed at 0%, while the portion of long-term gains and qualified dividends above that threshold is taxed at 15%
Note in this example that the client has $95,450 of taxable income. In 2024, this is how those capital gains and qualified dividends are taxed:
Most of this "qualified" income is taxed at 0%, with just a small portion taxed at 15%. Here's what things look like if you add $1,000 of ordinary income, which has the impact of increasing taxable income by a comparable $1,000:
In addition to the 12% marginal rate paid on that additional $1,000 of ordinary income, we've pushed an additional $1,000 of qualified income out of the 0% bracket and into the 15% bracket. Adding our 12% marginal rate to this 15% hit on that $1,000 of qualified income gets us to an effective 27% rate on that next $1,000 of ordinary income.
The comparison between our baseline scenario and one where we add $1,000 of ordinary income bears this out, as the resulting tax increase is $270. Accordingly, generating $270 of additional taxes by adding $1,000 of ordinary income results in an effective rate of 27% (270/1000 = 27%).
