A recent planning conversation began with a client considering Roth conversions.
The client wanted to understand the tax cost of converting dollars from a traditional IRA to a Roth IRA. Looking first at the federal tax brackets, the answer appeared straightforward. Most of the conversion would fall within the 10% and 12% marginal brackets.
Further analysis showed that the added income affected several parts of the return. A significant capital gain had already been realized earlier in the year. Before considering the Roth conversion, most of that gain fell within the 0% long-term capital gains bracket.
That additional conversion income reduced the amount of gain that remained within the 0% bracket. Some gains moved into the 15% bracket. Net Investment Income Tax applied to a larger percentage of gains. State taxes also applied.
The effective cost of the conversion was materially higher than the marginal tax bracket alone suggested. By the end of the analysis, we were focused on a different question:
What is the actual cost of the next dollar of ordinary income?
That question sits at the heart of the capital gains shadow tax.
How Ordinary Income Affects Capital Gains
Part of the planning conversation involves reviewing how long-term capital gains tax brackets work.
For 2026, married couples filing jointly remain within the 0% long-term capital gains bracket until taxable income exceeds $98,900. Income above that threshold generally falls within the 15% bracket until taxable income exceeds $613,700, at which point the 20% bracket begins.
The table below shows the 2026 long-term capital gains and qualified dividend tax brackets by filing status.
Like ordinary income tax brackets, long-term capital gains brackets operate marginally. A taxpayer with gains spanning multiple brackets may have some gains taxed at 0% and additional gains taxed at 15%.
Ordinary income fills the lower portion of the stack first. Wages, pension income, IRA distributions, Roth conversions, interest income, and similar sources of income occupy that space before long-term capital gains are layered on top.
One way to visualize the relationship is a glass containing water and oil. Ordinary income is the water. Long-term capital gains are the oil resting on top of it. As more water is added, the oil rises. Eventually some of the oil spills into the next bracket.
Suppose a married couple has $25,000 of ordinary income and $95,000 of long-term capital gains.
Most of the gain remains within the 0% long-term capital gains bracket because relatively little of that bracket has been used by ordinary income.
Now suppose the couple completes a $100,000 Roth conversion.
The additional ordinary income uses space that was previously available within the lower capital gains brackets. As ordinary income increases, a larger portion of the gain falls within the 15% bracket.
The conversion generates ordinary income tax while also increasing the tax paid on existing gains.
That is the concept behind the capital gains shadow tax.
Net Investment Income Tax
Net Investment Income Tax (NIIT) adds another layer to the analysis.
For 2026, NIIT generally applies once modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly. Long-term capital gains, dividends, interest income, rental income, and other forms of investment income may be subject to an additional 3.8% tax once those thresholds are crossed.
A Roth conversion increases modified adjusted gross income. The conversion itself is not investment income, but the higher income level may expose additional investment income to NIIT.
A Roth conversion, property sale, mutual fund distribution, or other income event can affect several parts of a tax return at the same time.
Similar taxable income does not always produce similar tax outcomes, which was central to the planning conversation that prompted this article. A return containing $350,000 of ordinary income can produce a very different result than a return containing $50,000 of ordinary income and $300,000 of long-term capital gains.
Two returns that appear similar at first glance may have very different costs for additional income.
Where Planning Opportunities May Exist
Charitable giving can be especially valuable during years with significant capital gains. A donor-advised fund, charitable gift, or other charitable strategy may reduce taxable income and create additional flexibility elsewhere on the return.
Tax-loss harvesting can offset realized gains and change the overall tax picture. The benefit depends on the amount and character of gains already recognized during the year.
The timing and size of a Roth conversion can influence the outcome. A year with substantial capital gains may look very different from a year with little or no realized gain.
Investors holding mutual funds may benefit from reviewing expected capital gain distributions before year-end. Those distributions can affect tax projections, particularly when large income decisions have already been made earlier in the year.
Questions Worth Asking Before Creating More Ordinary Income
A Roth conversion is one example of a decision that creates ordinary income. Large IRA withdrawals, deferred compensation distributions, consulting income, and other sources of income can create similar planning questions.
- How much of my long-term capital gain currently falls within the 0% bracket?
- How much ordinary income is already expected this year?
- Are mutual fund capital gain distributions expected before year-end?
- Are there qualified dividends that should be included in the analysis?
- What happens if I add another $25,000, $50,000, or $100,000 of ordinary income?
- How much gain moves from the 0% bracket into the 15% bracket?
- Does the additional income increase exposure to Net Investment Income Tax?
- How do state income taxes affect the result?
- Are charitable gifts already planned this year?
- Would tax-loss harvesting affect the outcome?
- Does spreading income across multiple years produce a different result?
- Would a different conversion amount better align with the overall tax picture?
Conclusion
Tax brackets provide a useful starting point for evaluating Roth conversions, IRA withdrawals, and other income-producing decisions.
Long-term capital gains, qualified dividends, Net Investment Income Tax, deductions, and state taxes can all influence the final result.
When evaluating a large income decision, I find it helpful to ask a simple question:
What is the actual cost of the next dollar of ordinary income?
About Weston Haaf, CFP®
Weston Haaf is the founder of Vantage Wealth Management and a CERTIFIED FINANCIAL PLANNER™ professional. He helps quietly successful couples—typically between $1 million and $15 million+ in assets—navigate retirement, tax strategy, and major financial transitions with clarity and purpose. Weston lives in Sunnyvale, TX, and believes great planning is as much about values and relationships as it is about numbers.
This post is for informational purposes only and is not intended as personalized financial, tax, or legal advice. Vantage Wealth Management is a registered investment advisor in the state of Texas. Registration does not imply any level of skill or training. Always consult with a qualified professional before making decisions based on this content.