Taxes are not only determined by how much income you receive but also by the type of income generated. Some income is taxed at ordinary rates, while other sources qualify for lower, preferential rates. Understanding how these different forms of income interact can open up valuable planning opportunities.
The U.S. tax code is progressive, meaning taxes are assessed at increasingly higher rates on increasingly higher incomes. It also treats ordinary income and preferential income differently. Ordinary income includes things like wages, interest, rental income, and withdrawals from traditional retirement accounts. These are taxed using the standard progressive tax brackets. Qualified dividends and long-term capital gains are taxed at lower rates, typically 0%, 15%, or 20%. The table below shows the 2025 Federal tax rates to illustrate how various rates apply based on your taxable income each year.
| Federal Income Tax | |||
|---|---|---|---|
| Rates apply to taxable income | |||
| 2025 Tax Rate | Married Filing Jointly | Single | |
| 10% | $0 - $23,850 | $0 - $11,925 | |
| 12% | $23,851 - $96,950 | $11,926 - $48,475 | |
| 22% | $96,951 - $206,700 | $48,476 - $103,350 | |
| 24% | $206,701 - $394,600 | $103,351 - $197,300 | |
| 32% | $394,601 - $501.050 | $197,301 - $250,525 | |
| 35% | $501,051 - $751,600 | $250,526 - $626,350 | |
| 37% | Over $751,600 | Over $626,350 | |
| Long-Term Capital Gains Tax | |||
|---|---|---|---|
| Rates apply to long-term capital gains and qualified dividends based on taxable income | |||
| Filing Status | 0% Rate | 15% Rate | 20% Rate |
| Married Filing Jointly | ≤ $96,700 | $96,701 - $600,050 | ≥ $600,050 |
| Single | ≤ $48,350 | $48,351 - $533,400 | ≥ $533,400 |
Preferential Income Stacking
One area that can make a meaningful difference is how different types of income are layered within the tax system. Preferential income stacking refers to the way the IRS applies taxes to qualified dividends and long-term capital gains. These types of income are taxed at reduced rates, typically 0%, 15%, or 20%, depending on your overall income level. However, these reduced rates only apply after your ordinary income is taken into account.
However, when calculating your tax bill, the IRS does not evaluate each type of income in isolation. Instead, it layers them. Your ordinary income (which is taxed at the highest rates) fills up the tax brackets first. Once those dollars are accounted for, your qualified dividends and long-term capital gains (taxed at lower, more preferential rates) are added on top. This is what creates the stacking effect.
For example, suppose that a married couple has $90,000 of ordinary income and $60,000 of long-term capital gains. For 2025, the 0% rate on capital gains generally applies until their total income reaches around $97,000. In this case, having $90,000 of ordinary income means that only the first $7,000 of capital gains will be taxed at 0%. The remainder of the gains would be taxed at 15%.
This stacking effect means that capital gains and dividends are not taxed in a vacuum. Their tax treatment depends on what came before them in the income sequence.
When It Can Be Useful
Preferential income stacking creates opportunities for individuals and couples who can control the timing and source of their income to avoid “filling” the lower tax brackets with ordinary income. It is especially relevant for those who are:
- Early retirees who are not yet drawing from retirement accounts
- Households living off cash savings or Roth withdrawals
- Managing income from a combination of taxable, tax-deferred, and tax-free accounts
- Charitably inclined individuals using Qualified Charitable Distributions (QCDs) to reduce their taxable income
In any of these situations, it may be possible to limit ordinary income and create more room for capital gains and dividends to be taxed at the lower 0% or 15% rates.
Where It May Fall Short
For high-income households, the benefits of preferential stacking may be limited. Larger distributions from IRAs, pensions, or other ordinary income sources can crowd out the lower tax brackets. In some cases, this can also trigger additional tax consequences, such as:
- A greater portion of Social Security benefits becomes taxable
- Higher Medicare premiums due to income-related surcharges
- Exposure to the 3.8% net investment income tax on capital gains
These effects can combine, resulting in a higher effective tax rate than you might expect. Without planning, the advantage of the lower capital gains rates can erode quickly.
Practical Application
Preferential stacking is most powerful when it’s part of a broader income strategy. The goal is not to avoid taxes entirely, but to make sure each type of income is taxed as favorably as possible. Strategies can be used to fill lower brackets when taxable income is lower or to reduce taxable income when the applicable rates are higher.
A few planning ideas include:
- Capital gain harvesting: Selling appreciated investments in low-income years to reset the cost basis while paying lower tax rates than anticipated in future years.
- Roth conversions: Converting traditional IRA assets to Roth IRAs in years when ordinary income is low, potentially reducing your required minimum distributions (RMDs) later.
- Withdrawal sequencing: Balancing distributions from taxable, traditional, and Roth accounts to manage ordinary income and tax brackets.
- Charitable giving: Using Qualified Charitable Distributions (QCDs) to reduce ordinary income and keep more space available for lower capital gains rates.
Each of these tactics is meant to improve the efficiency of how income is taxed. It can also have ripple effects by keeping Medicare premiums lower or reducing taxes on Social Security. Over time, managing income in this way can reduce total taxes paid across a multi-year retirement plan. It can also improve flexibility. For example, if you know your capital gains will be taxed at a lower rate, you might feel more comfortable drawing from a taxable account to fund a large expense or support a child or grandchild.
Preferential income stacking is one of those technical details that can significantly impact your tax efficiency when planning for retirement income. With careful coordination across account types, investment strategies, and charitable giving, it becomes possible to manage taxes more effectively and preserve a greater portion of your wealth.
Of course, preferential income stacking is most effective when it’s aligned with your overall retirement income approach. That’s where the RISA® (Retirement Income Style Awareness) framework comes in.
The RISA® helps you understand your personal preferences for generating retirement income -whether you value flexibility, predictability, or a combination of both. Once you know your style, you can tailor strategies like income stacking, Roth conversions, and withdrawal sequencing to better match your goals.
Want to learn more? Listen to Ep. 186 of the Retire With Style Podcast.
