If you are married filing jointly with taxable income of $77,400 or less, you are in the 12% tax bracket. However, add $1 more and you are in the 22% bracket. See how that works? $77,400 = 12% bracket. $77,401 = 22% bracket.
This is how marginal rates work: the more income you receive the higher the tax rate on that additional income will be. The tax you paid on your previous income doesn’t change though. You only pay higher taxes on the amount that puts you into the next bracket.
How Qualified Dividends and Long-Term Gains Are Taxed
Now, let’s say you have total income of $70,000 which consists of $60,000 of work income and $10,000 in the form of Qualified Dividend Income (QDI) and Long Term Capital Gains (LTCG). But you need $80,000 to maintain your lifestyle. So you take a $10,000 distribution from your IRA. That puts you in the 22% tax bracket.
The following April you go visit your tax guy to file your taxes. Your tax guy gives you what you initially thought to be a pleasant surprise. He says that you only have to pay 15% on the $10,000 you received as dividends and capital gains even though you are in the 22% tax bracket. This is good news, right?
Unfortunately, the reason you’re in the 22% bracket to begin with is the IRA distribution put you there. Now, you owe over $3,000 in taxes. This is bad.
You wise up and use a different strategy for the following year. You still need $80,000 to get by. You’re still only making $70,000 from work and dividends. To make up the difference this year you take a distribution from your Roth IRA, not your Traditional.
Now, when you go back to your tax guy you really do get a pleasant surprise: you pay $3,000 less in taxes! “Wait a second. How can this be?” You ask.
Your tax guy explains. “Your IRA distribution last year not only increased your marginal tax rate to 22% but it also made your dividends and capital gains taxable as well. That $10,000 IRA distribution cost you $1,500 in income tax plus $1,500 in taxes on your dividends and capital gains. A double-whammy if ever there was one!
“Because your Roth distribution is tax free you remain in the 12% bracket. Taxpayers who are in the 10% or 12% brackets do not pay tax on their qualified dividends or long term capital gains. So, not only do you not pay taxes on your Roth, you don’t pay taxes on your other investment income either!”
Isn’t the Roth beautiful?