How does the IRS tax different income sources at different rates when they're all combined on Form 1040?

The key is that your income sources are totaled on your Form 1040, but they're actually calculated separately before being combined into your final tax bill. When you prepare your taxes, you'll report your W-2 wages and they'll be taxed according to the regular income tax brackets. For your long-term capital gains, those get reported on Schedule D and Form 8949, and they're taxed separately using the capital gains tax rates (0%, 15%, or 20% depending on your income level). Think of it this way: your tax preparation process has multiple "lanes" running simultaneously. Each type of income runs in its own lane with its own tax calculation. Then at the end, the total tax from each lane gets combined into your final tax bill on the 1040. The IRS keeps track of your different income types through the various forms and schedules that feed into your 1040. Your capital gains don't actually get "blended" with your ordinary income for tax rate purposes, even though they both contribute to your total income.

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To add to what others have said, the form that actually handles these separate calculations is the "Qualified Dividends and Capital Gain Tax Worksheet" in the 1040 instructions. That's where the magic happens! Your different income types get separated out and taxed accordingly, even though they're all reported on the 1040. The worksheet applies the correct tax rates to each "bucket" of income: - Ordinary income (wages, interest, etc.) at regular tax brackets - Qualified dividends and long-term capital gains at 0%/15%/20% depending on your income The worksheet then combines all these separate calculations to determine your total tax.

I found this confusing too until my accountant explained it. Here's a simplified example: Let's say you have: - $70,000 in wages - $8,000 in long-term capital gains Your total income is $78,000, but the tax calculation happens like this: 1. Your $70,000 wages are taxed using regular tax brackets 2. The $8,000 LTCG is taxed at the capital gains rate (0%, 15%, or 20%) 3. These separate tax amounts are added together for your final tax bill It's almost like having two separate tax returns that get combined at the very end!