Different kinds of income are taxed differently under the United States tax system and two of the major distinctions are between ordinary income tax and capital gains tax. Ordinary income tax applies to income earned from regular activities such as wages, salaries and commissions. It also applies to interest earned on bank deposits. Capital gains tax applies when you sell a capital asset such as a stock, bond, real estate or other investment for more than you paid for it. A financial advisor can help you account for different taxes on types of income.
Ordinary Income Tax
Income earned from working for wages, salaries and commissions, as well as income earned from interest paid on bank deposits, is taxed as ordinary income. This type of income is taxed at your regular tax rate, also known as your marginal tax rate.
The marginal rate is determined by tax brackets. The IRS publishes annually updated income ranges for seven tax brackets that go from 10% to 37%. The percentage of tax applied increases as income rises.
For a simplified example of how this works that doesn’t account for deductions and other factors, a taxpayer who earns a $75,000 salary in 2023 will be taxed using the following tax brackets:
- 10% on the first $11,000 = $1,100
- 12% on the amount over $11,000 and up to $44,725. This amount is $33,725, so the tax would be $4,047
- 22% on the amount over $44,725 and up to $75,000. This amount is $30,275, so the tax would be $6,660.50.
The total tax on ordinary income in this simplified example is $1,100 + $4,047 + $6,660.50 = $11,807.50.
Capital Gains Tax
Capital gains tax applies when you sell a capital asset for more than you paid for it. Capital assets include stocks, bonds, jewelry, real estate and other investments. The tax rate varies depending on whether it’s a short-term or long-term capital gain and also on your income. Different capital gains tax rates may apply to specific types of assets as well.
Short-term capital gains result from sales of assets held for a year or less. These capital gains are taxed at your ordinary income tax rate. So, if you sell a stock you owned for six months and make a $10,000 profit, this will be added to your ordinary income and taxed accordingly.
Long-term capital gains from sales of assets held for more than a year receive a more favorable tax rate. Long-term capital gains rates for 2023 are 0%, 15% or 20% depending on your income.
For example, if you sell a stock you held for two years and make a $20,000 profit, the tax on this gain would be:
- 0% if your taxable income, including the gain, is up to $40,400
- 15% if your taxable income is more than $40,400 but not more than $445,850
- 20% if your taxable income is over $445,850
To combine this with the previous example involving an ordinary income of $75,000, adding a $20,000 long-term capital gain results in a total income of $95,000. This would place you in the 15% bracket for long-term capital gains. The additional tax on your $20,000 gain would be 15% of $20,000 or $3,000, increasing your total tax bill including ordinary and capital gains tax to $14,807.50.
Special Considerations
In addition to the basic rates, high-income investors may also have to pay an additional 3.8% net investment income tax. Also, certain types of assets have specific rules. For example, capital gains on sales of collectibles such as art and jewelry are taxed at a flat rate of 28%.
As well as making gains when selling assets, you may also experience losses. These losses can be used to reduce your overall capital gains for a given tax year and potentially reduce the taxes you owe. An investing strategy called tax-loss harvesting can be employed to make the most of money-losing asset sales.
The Bottom Line
Ordinary income tax applies to regular earnings like wages, salaries and interest and is taxed at your marginal tax rate, which varies from 10% to 37% depending on your income. Capital gains tax, charged when selling assets for a profit, varies depending on how long you owned an asset. Short-term gains on assets held a year or less are taxed as ordinary income, while long-term gains held for over a year have generally lower tax rates.
Tips for Tax Planning
- Careful tax planning is one of the most effective ways to increase your income and wealth and talking to a financial advisor can help with this important task. Finding a financial advisor doesn’t have to be hard.SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Check out SmartAsset’s Capital Gains Tax Calculator to find out how much tax you’ll owe when selling investments.
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FAQs
Ordinary income tax applies to regular earnings like wages, salaries and interest and is taxed at your marginal tax rate, which varies from 10% to 37% depending on your income. Capital gains tax, charged when selling assets for a profit, varies depending on how long you owned an asset.
How will you distinguish between capital gain and income? ›
Capital gains and other investment income differ based on the source of the profit. Capital gains are the returns earned when an investment is sold for more than its purchase price. Investment Income is profit from interest payments, dividends, capital gains, and any other profits made through an investment vehicle.
What is the main difference between earned income and capital gains? ›
Earned income is payment for employment, while capital gains are produced by your investments.
What counts as ordinary income? ›
Examples of ordinary income include salaries, tips, bonuses, commissions, rents, royalties, short-term capital gains, unqualified dividends, and interest income. For individuals, ordinary income usually consists of the pretax salaries and wages they have earned.
Are capital gains against ordinary income? ›
A capital gain is the profit you receive when you sell a capital asset, which is property such as stocks, bonds, mutual fund shares and real estate. Short-term gains come from the sale of assets you have owned for one year or less. They are typically taxed at ordinary income tax rates, as high as 37% in 2023 and 2024.
Is capital gains tax based on gross income or taxable income? ›
Federal long-term capital gains tax rates are based on adjusted gross income (AGI). The basic capital gains rates are 0%, 15%, and 20%, depending on your taxable income. The income thresholds for the capital gains tax rates are adjusted each year for inflation.
What is the difference between capital and income? ›
Capital includes all assets (cash, investments, buildings, machinery etc.) that have value. Income is money that is earned. It can be earned by capital (interest on a bank account, profit from a business, dividends from stock), or by labour (payment for work done).
How do I avoid capital gains on my taxes? ›
How to Minimize or Avoid Capital Gains Tax
- Invest for the Long Term. You will pay the lowest capital gains tax rate if you find great companies and hold their stock long-term. ...
- Take Advantage of Tax-Deferred Retirement Plans. ...
- Use Capital Losses to Offset Gains. ...
- Watch Your Holding Periods. ...
- Pick Your Cost Basis.
By favoring present over future consumption, savings are discouraged, which decreases future available capital and lowers long term growth. Not only has a low capital gains tax rate worked to encourage savings and increase economic growth, a low capital gains rate has historically raised more in tax revenue.
Do capital gains increase your tax bracket? ›
Long-term capital gains can't push you into a higher tax bracket, but short-term capital gains can. Understanding how capital gains work could help you avoid unintended tax consequences. If you're seeing significant growth in your investments, you may want to consult a financial advisor.
Short-term capital gains are taxed at the same rate as your ordinary income. Meanwhile, long-term gains are taxed at either 0%, 15%, or 20%. The rate you pay is based on your taxable income. Just like with ordinary income tax rates, the higher your income, the higher your long-term capital gains tax rate.
What is substitute for ordinary income? ›
The substitute for ordinary income is a doctrine the IRS applies at times to certain sales of assets to make the money earned taxable as ordinary income. Assets that give you taxable income either at present or in the future won't count as capital gains but instead will count as ordinary income.
How much is ordinary income taxed? ›
Tax brackets 2024 (taxes due April 2025)
| Tax rate | Single | Head of household |
|---|
| 10% | $0 to $11,600 | $0 to $16,550 |
| 12% | $11,601 to $47,150 | $16,551 to $63,100 |
| 22% | $47,151 to $100,525 | $63,101 to $100,500 |
| 24% | $100,526 to $191,950 | $100,501 to $191,950 |
3 more rowsApr 30, 2024
Gains from the sale of assets you've held for longer than a year are known as long-term capital gains, and they are typically taxed at lower rates than short-term gains and ordinary income, from 0% to 20%, depending on your taxable income.
How is capital gains tax calculated with ordinary income? ›
How do capital gains taxes work? Capital gains can be subject to either short-term tax rates or long-term tax rates. Short-term capital gains are taxed according to ordinary income tax brackets, which range from 10% to 37%. Long-term capital gains are taxed at 0%, 15%, or 20%.
Can capital gains losses offset ordinary income? ›
If you have more capital losses than gains, you may be able to use up to $3,000 a year to offset ordinary income on federal income taxes, and carry over the rest to future years.
Why is it important to distinguish between income and capital? ›
Distinction between income and capital
The distinction is the most fundamental basis upon which our system of taxation depends. Ours is a tax upon income and not upon capital. The latter is brought to tax only to the extent of a gain and then only upon disposal.
What is the difference between income distribution and capital gain distribution? ›
A mutual fund dividend is income earned by the fund from dividends and interest paid by the fund's holdings. A capital gain distribution occurs when the fund sells assets during the year and the gains on those sales exceed the losses.
What is the relationship between capital and income? ›
Capital is a major input to income. Income is the cheapest form of capital infusion. "There are two ways to view the relationship between capital and income: In a static framework..., its capital value will simply be the present discounted value of those future cash flows.
What is an example of income from capital gains? ›
Example: Manya bought a house in July 2004 for Rs.50 lakh, and the full value of consideration received in FY 2016-17 is Rs.1.8 crore. Capital asset type: Since this property has been held for over 3 years, this would be a long-term capital asset. Capital gain: Hence, the net capital gain is Rs 63, 00,000.
