By Dr. Jim Dahle, WCI FounderPart of financial literacy is understanding how the tax code works. Unfortunately, that is a major undertaking. Today, we are going to look at a tiny part of the tax code and discuss why it matters to white coat investors. The text for our sermon can be found in an obscure worksheet in the Form 1040 Instructions, specifically the Qualified Dividends and Capital Gains Tax Worksheet — Line 16. This isn't even a form you submit to the IRS. If you pay someone else to prepare your taxes or if you prepare your own taxes using software, you may have never seen this worksheet.
Nevertheless, it is important to understand how it works and what it means.
What Are Qualified Dividends?
Before we get into the worksheet, we should do a few definitions. Investors are often paid dividends by their investments. Dividends are generally taxed at your ordinary income tax rates. However, some dividends are special. They are qualified with the IRS for a special, lower tax rate. The qualified dividend tax brackets are 0%, 15%, and 20%—much lower than the ordinary income tax rates ranging from 10%-37%. Note that most states do NOT offer a lower tax rate on qualified dividends.
A qualified dividend is paid by a C Corporation whose shares you owned for at least 60 days, although that 60 days can be split in any way around the ex-dividend date. If you bought it five days before the ex-dividend date and sold it 12 days afterward, that dividend is NOT a qualified dividend, and you will pay at ordinary income tax rates on it. (It's something to be careful about when tax-loss harvesting). Qualified dividends show up on line 3a of Form 1040. Note that the ordinary dividends line (3b) includes unqualified and qualified dividends.
What Are Capital Gains?
Capital gains and losses occur when you sell an investment. If you sold it for more than you paid for it, then you have a capital gain in the amount that the price you sold for exceeds the amount you paid (the basis). If you sold it for less, you have a loss. If you owned it for 366 days or more, that is a long-term capital gain or loss. If you owned it for 365 days or less, that is a short-term capital gain or loss. Long- and short-term capital gains and losses are totaled up on Schedule D. First, short-term capital gains and losses are zeroed out against each other (line 7), and then long-term capital gains and losses are zeroed out against each other (line 15). Then, the magic happens in Part III of Schedule D.
First, in line 16, you sum the long-term and short-term numbers together. If it is a gain, you enter that gain on line 7 of Form 1040 that we saw above and go to the next line. If it is a loss, you skip the next few lines and go to line 21.
When You Have a Gain
In line 17, you have to look at whether you have a long-term gain AND a total (long-term plus short-term) gain. If you do, look and see if you have a gain on collectibles (gold, Beanie Babies, etc.). You have to pay 28% on those. You also look to see if you have an unrecaptured Section 1250 gain. This is the depreciation recapture tax when you sell a real estate investment that you have been depreciating. This is taxed at a maximum of 25%. If you don't have either of those, go on to the Qualified Dividends and Capital Gains Tax Worksheet (the subject of this blog post.) If you have those, you go to a different worksheet found in the Schedule D Instructions. It's quite a complicated two-page form. Think of it as the complicated version of the Qualified Dividends and Capital Gains Tax Worksheet for those dumb enough to invest in Beanie Babies. Just kidding. It's no big deal to complete, just a few extra lines (although if you're doing it by hand, you're a glutton for punishment). Why these two forms that do the same thing are in completely separate IRS instructions is beyond me.
If you have a total gain but a long-term loss, you are now on line 22. It asks about qualified dividends. If you have those, you'll need to fill out the Qualified Dividends and Capital Gains Tax Worksheet next. Otherwise, you're done with Schedule D, and you'll be paying ordinary income taxes on everything on line 7 because those are short-term gains. Note that your long-term losses did offset your short-term gains.
When You Have a Loss
When you have a total loss, you go to line 21. You put that loss or $3,000, whichever is smaller, on Line 7 of your 1040. This is the $3,000 capital loss deduction that you can use against your ordinary income each year with the rest carried forward. Then, go to line 22. If you have dividends, you have to go on to the Qualified Dividends and Capital Gains. If you do not, you're done with Schedule D.
More information here:
13 Ways to Lower the Tax Bill on Your Income
The Qualified Dividends and Capital Gain Tax Worksheet
Now we move into the relatively detailed Qualified Dividends and Capital Gain Tax Worksheet. If you don't want to work through this with me, that's fine. Just skip it. Down below, I'll illustrate the lessons one can learn by working through it.
The worksheet begins with your taxable income on the first line. On lines 2-5, you essentially subtract your capital gains and dividends from the taxable income.
Lines 6-21 seem ridiculously complicated. Just follow the instructions carefully, and it's no big deal. What you are doing on these lines is simply calculating the tax due on your qualified dividends and long-term capital gains. Line 9 tells you the amount in the 0% qualified dividend/LTCG bracket, line 18 tells you the amount in the 15% qualified dividend/LTCG bracket, and line 21 tells you the amount in the 20% qualified dividend/LTCG bracket.
Now, you calculate the tax due on your income that is not qualified dividends/LTCGs on line 22.
On line 23, you add all of that tax together. You make sure it isn't less than you would pay if you didn't have any qualified dividends or LTCGs on line 24. I can't imagine that happens very often. I'm sure there's a scenario where it does (or this line wouldn't be here), but I can't think of it. Line 23 should almost always be less than line 24, so that's what goes on line 25. That is transferred to Form 1040 Line 16 as your “Tax.” You add some more taxes to it (like self-employment tax, Obamacare taxes, and household employee taxes from Schedule 2) on 1040 lines 17 and 18, and then you add in your credits and payments to find out how much total tax you owe. Compare that to what you paid and settle up with the IRS to be done with your federal income taxes.
More information here:
Tax Policies: Enjoy Them but Also Reform the Right Ones
Lessons Learned from the Qualified Dividends and Capital Gains Tax Worksheet
The most important lesson to learn from this worksheet is that qualified dividends and capital gains stack on top. What does that mean?
The first thing it means is that doubling or tripling your qualified dividends and capital gains does not push you into a higher ordinary income tax bracket. If you've got $100,000 in ordinary income, it doesn't matter if you have $100,000 in dividends or $1 million in dividends. That ordinary income is going to be taxed at the same rate (although it could be affected by some deduction phaseouts based on AGI.)
The second thing it means is that the opposite is not true. Increasing ordinary income can push your qualified dividends and capital gains into higher brackets. Let's say a single person has $30,000 of taxable ordinary income and $5,000 in qualified dividends. Those dividends are taxed at 0%. But if that person gets a better job and now has $60,000 of taxable ordinary income and $5,000 in qualified dividends, the dividends are taxed at 15%.
In an example more relevant to those on this website, if you're Married Filing Jointly and go from a taxable ordinary income of $400,000 to $600,000, your $100,000 in qualified dividends are now going to be taxed at 20% instead of 15%. If you had increased your dividends by $200,000 instead of your ordinary income by $200,000, only $200,000 of your now $300,000 of dividends would be taxed at 20%, because dividends stack on top.
The third thing it means is that your deductions are taken from your ordinary income, NOT your capital gains. This is not so intuitive, but it is indeed the way it works because of this worksheet. By the time you get to line 15 of the 1040 ( line 1 on the worksheet), you've already applied all of your above-the-line and below-the-line deductions to arrive at your taxable income. THEN, you subtract your entire sum of qualified dividends and LTCGs from that taxable income amount. Thus, the deductions apply to ordinary income, NOT qualified dividend/LTCG income.
Qualified dividends and long-term capital gains (as well as collectibles, capital gains, and depreciation recapture tax) always stack on top, and that is a good thing for you, the taxpayer.
If you need help with tax preparation or you’re looking for tips on the best tax strategies, hire a WCI-vetted professional to help you figure it out.
What do you think? Did you ever consider this before? Will it affect the way you arrange your financial life?
Great article – thank you. Could someone explain to me what “dividends stack on top “ mean in the example used above? What does it stack on top of specifically? Thx
It means that the tax on your qualified dividends and long term capital gains are added to the tax you pay on ordinary income. It also means that qualified dividends and LTCG don’t alter the taxes you pay on ordinary income, like that from your W2 job.
This doesn’t answer the question. It’s clear that LTCG stack on top of ordinary income. But do qualified dividends stack on top of LTCG or on top of ordinary dividends? In other words, can LTCG push your dividends into a higher dividend tax bracket?
on top of ordinary dividends and all other income. LTCG and QD are all in the same bracket so it doesn’t matter.
Very helpful!
Question: I am planning to purchase my next home using funds from my taxable account in the next 2-3 years. If I time my one year unpaid sabbatical to be the same year I sell the stocks in my brokerage account (those held >365 days), does this mean that my dividends would be taxed at 0%?
Thank you!
At least some of them will be. If you have too many gains, some of them may be taxed at 15%.
Thank you. Seems like I should have had this epiphany in the last 25 years of doing my taxes and receiving qualified dividends and capital gains (QDCG), but this year it had to come again: I was wrongly thinking “I can’t decide how much in Roth conversions to do to max out this tax bracket until I know how much I have in end of year passive capital gains from my mutual funds”. Finally I recognized that ONLY other income (salaries, pensions, etc.) and nonqualified dividends and capital gains (regular income) would put me in a different tax bracket (Obamacare taxes aside? Not gonna tax my brain sorting that out.)
Serge H- this is “Stack on top”: QDCG tax rates are determined more by the other income and do not increase the rates of tax on that other “regular” income.
Hi Jenn there is an instance where do have to be careful with Roth conversions given that you might push your qualified dividends and cap gains from the 0% to the 15% LTCG tax brackets. If you are near crossing those tax brackets, I would suggest you still do the “I don’t know how much Roth conversion I can do until I know my passive gains” approach. A Roth conversion might push some long term gains into the 15% tax bracket, essentially meaning that money is being taxed at 12% (ordinary income tax bracket from Roth conversion) + 15% (LTCG tax bracket), or 27%!
I hope that makes sense. and hopefully you have a nice nest egg where you drawing way above the top of the 0% LTCG bracket!
Money is being taxed at 27%??!!
The math seems off — one does not add the (marginal) tax bracket rates for the two taxable pots of money (Ordinary Income and Capital Gains/Qualified Dividends) to come up with a (still marginal?) overall tax rate.
The article explained the possible risk with ROTH conversions (the Capital Gain/Qualified Dividend money can find itself taxed at a higher marginal rate). There was no mention of *adding* tax rates together. The commenter seems to have misconstrued the article … or perhaps I am the one overlooking something? As WCI hasn’t weighed in earlier, I am not sure ….
Yeah dude I didn’t believe it myself but Kitces has a nice article about it:
https://www.kitces.com/blog/long-term-capital-gains-bump-zone-higher-marginal-tax-rate-phase-in-0-rate/
He calls it the “capital gains bump zone”. Jenn just has too look out if her qualified dividends and LTCG’s are entering that 15 LTCG tax bracket.
Dudess, but no matter. 🙃
Ya gotta luv Kitces. Thanks, Rikki and WCI.
Interesting article. I question some of Kitces’ math (specifically in Example #1 of the article), but the principles seem solid nonetheless.
The easiest way to figure it out is with tax software. Do your taxes. Now add the income. What happened to your tax bill? That will take into account the brackets and phaseouts. I’d do that to double check, but I think Rikki’s math is probably right. Not only are you paying on the converted amount at whatever rate, but pushing capital gains out of the 0% bracket adds an additional tax cost.
What’s happening is that additional ordinary income like a conversion from a pre-tax to post-tax account (i.e a distribution) gets taxed at it’s marginal rate. Take another 10k out at the 12% marginal bracket, and you’re taxed 1,200 more dollars federal.
If you have long term capital gains that was previously being taxed at the 0% rate but is now being taxed at the 15% rate due to being pushed into that rate by the increase in ordinary income, you’re now getting taxed at that 15% rate for the LTCG. That 10K of ordinary income bumped 10K of capital gains out of the 0% tax rate bucket and into the 15%, meaning you’re paying additional taxes of $1,500 that you hadn’t been prior to the ordinary income.
The reason it feels like a bit of a trap is because the additional 10K in ordinary income is not only taxed on its own but also pushes previously untaxed capital gains into a taxable bracket.
Here’s an infographic from that Kitces article that Rikki linked demonstrating how that works. https://www.kitces.com/wp-content/uploads/2019/01/Graphic_6aa.png
Thanks for this great clarifying article!
I know it should be obvious (but I can’t figure it out): Where on the capital gains worksheet does one see the capital gains losses that they are carrying over into the next year?
You mean capital losses, not capital gains losses.
The carryforward happens on Schedule D, lines 6 and 14. But those do come from the Capital Loss Carryover Worksheet, which can be found in the Schedule D instructions. It’s on page D-11 in the one I’m looking at.
Does that help?
Thank You–I could never find this before.
($16,412 carryover to 2023. )
Dr. Dahle is correct. This worksheet is often overlooked. Users of my free online Federal Income Tax Spreadsheet routinely report what they believe is an error in my spreadsheet’s tax calculation. Every time, I’d ask if they remembered to complete the QDCG tax worksheet when the manually calculated their return. Every time, they would reply saying that they had neglected to do so. Sometimes my spreadsheet had automatically calculated a lower tax by several hundred dollars because of this worksheet. Taxpayers are always pleased to find out that they will be paying less taxes.
Mr./ Dr. Reeves whatever you are, thank you so much for this spreadsheet! The IRS forms that are fillable ok fine and then my day is blighted when I need data I have to do on paper or make my own spreadsheet (QDCGTW, SS calculator for my in-laws, etc.). (especially since I have to open a file on the computer and find the page that form is on… almost makes me miss paper).
Thank you for the straightforward approach and clear explanations. Really appreciate your efforts.
Merry Christmas, a day late!
MLT
Thanks for the article. Every December, I look at my bar charts and notes from the previous year in order to wrap my brain around how the OI and QI buckets work. Adding your article to my bookmarks will definitely help!
I use tax software but I like to understand where my qualified dividends and capital gains are being taxed. I worked through the H&R Block worksheet and was very upset that I really was not getting the full benefit of the MFJ deduction. They always take your regular taxable income away from this MFJ amount of $89,250 and that is what you pay 0% on . They take your full taxable income less 89,250 dollars and the balance you pay 15% on then you get to pay taxes on the regular amount. It seemed to me that I was being taxed twice on the amount which exceeded my combined qualified dividends and my net LTG. This article helped me out somewhat now I know it ll begins with my ordinary taxable income and everything else gets stacked., so in my case I got some at 0% and the rest was at 15%. This was the only article I found on the web. I have signed up for your weekly blog and newsletter.
Glad to be able to help.
WCI,
This is fairly straight forward if you aren’t retired and receiving Social Security, but for high earners with high SS this becomes a different ball game, where a simple Roth Conversion (or block of ordinary income) can add a marginal tax near 40% when you thought you were in the 12% bracket, based on a large SS benefit and large taxable account with lots of Qualified Dividends.
Have you written any articles that cover this? I am guessing you must have but a quick look under SS topics didn’t find any.
I recently wrote this article, that discusses some of the issues:
https://seekingalpha.com/article/4667028-risk-of-the-roth-ira-revolution-and-social-security
The bottom line when you really dig into it is that many people are doing Roth conversions thinking the marginal tax is in the 12% bracket or at worst 22%, but if your SS is greater than about $61k you could very easily be doing conversions near or above 40% and that is without any State tax which pushes it higher yet.
This article indicates it is published December 2023 but the Qualified Dividends and Capital Gains Tax sheet is not for 2023 returns. Please update your content.
It’s hard to keep all 3000 blog posts updated at any given moment but we do the best we can. I think in this case when I wrote the article in early 2023 the 2023 tax forms were not yet available. In fact, they probably weren’t available when the post was published either. Here are links to the current forms:
https://www.irs.gov/pub/irs-pdf/f1040.pdf
https://www.irs.gov/pub/irs-pdf/f1040sd.pdf
https://www.irs.gov/pub/irs-pdf/i1040gi.pdf page 37
They look awfully similar to the 2022 forms to me. What are you seeing that’s different?
Line 6 changes every year. I couldn’t figure out why my refund was different than the IRS’s. Luckily they found the error and gave me a higher refund. It was a big task figuring it out.
Hi… Thanks. To me, line 9 is confusing. Is it (line 7 – line 8) or (line 7 – line 8) x 0%, which is 0?
You don’t multiply it by 0%. It’s just like a “for your information” line. It just tells you how much income you got that wasn’t taxed.
Thank you so much. This is very kind of you.
I am a complete novice. You answered my question (I think) about what to enter on lines 15 & 16 of 1040SR. I had to trust that the IRS would understand that the tax was not based on the amount on line 15. THANK YOU!
Pr;obably best that I not subscribe
I have never found an answer to this question: On the Qualified Dividends and Capital Gains Worksheet, if it asks for the “smaller of two numbers” and the two numbers are the same, what goes in the blank? If I put one of the equal numbers, I obviously get a different result than if I leave it “zero.”
If it says the smaller and they’re the same, use either one.
Via email:
After reading the article, and doing some ‘reverse engineering’ of the Qualified Dividends and Capital Gains Tax Worksheet, and playing with the AARP’s tax calculator a bit – I’ve come away with these takeaways, that I thought you might be interested in:
1) When using the worksheet, there are actually two deductions that are applied to total income. The first is the standard or itemized deduction, on 1040, line 12. The second is up to $94,050 (for married filing jointly) on line 6 of the worksheet.
2) The sweet spot is where ordinary income is equal to the first deduction (on 1040, line 12). This results in line 5 of the worksheet being zero, then the entire $94,050 deduction (above) being applied. So, the first $94,050 of taxable income (on 1040, line 15) is taxed at 0%, then the portion in excess of $94,050 (up to $583750) is taxed at 15%.
3) If ordinary income is greater than the first deduction, this reduces the amount of the second deduction. This results in the portion of ordinary income in excess of the first deduction being taxed at 25% or more.
4) If ordinary income is less than the first deduction, then the taxpayer may be missing out on an opportunity to take more ordinary income at a favorable tax rate of only 15%. For example, this could be an opportunity to roll-over some funds from a traditional IRA to a Roth, with only a 15% tax hit.